Question 3 Case Study 2 (19 marks)

Jazz Instruments Limited, located in Nelson, South Island has a newly appointed vice president of finance. He is Austin Martin. Austin was eager to talk to his investment banker about future financing for the firm. One of Austins first assignments was to determine the firms cost of capital. In assessing the weights to use in computing the cost of capital, he examined the current balance sheet, presented in Figure 1.

In their discussion, Austin and his investment banker determined that the current mix in the capital structure was very close to optimal and that Berkshire Instruments should continue with it in the future. Of some concern was the appropriate cost to assign to each of the elements in the capital structure. Austin requested that his administrative assistant provide data on what the cost to issue debt and preferred stock had been in the past. The information is provided in Figure 2.

When Austin got the data, he felt he was making real progress toward determining the cost of capital for the firm. However, his investment banker indicated that he was going about the process in an incorrect manner. The important issue is the current cost of funds, not the historical cost. The banker suggested that a comparable firm in the industry, in terms of size and bond rating. (RI), Raimonds Instruments, had issued bonds a year and a half ago for 9.3 percent interest at a $1,000 par value, and the bonds were currently selling for $890. The bonds had 20 years remaining to maturity. The banker also observed that Raimonds Instruments had just issued preferred stock at $60 per share, and the preferred stock paid an annual dividend of $4.80.

In terms of cost of common equity, the banker suggested that Austin use the dividend valuation model as a first approach to determining cost of equity. Based on that approach, Austin observed that earnings were $3 a share and that 40 percent would be paid out in dividends (D1). The current stock price was $25. Dividends in the last four years had grown from 82 cents to the current value. The banker indicated that the under-writing cost (flotation cost) on a preferred stock issue would be $2.60 per share and $2.00 per share on common stock. Austin further observed that his firm was in a 35 percent marginal tax bracket.

With all this information in hand, Austin sat down to determine his firms cost of capital. He was a little confused about computing the firms cost of common equity. He knew there were two different formulas: one: one for the cost of retained earnings and one for the cost of new common stock. His investment banker suggested that he follow the normally accepted approach used in determining the marginal cost of capital. First, determine the cost of capital for as large a capital structure as current retained earnings will support; then, determine the cost of capital based on exclusively using new common stock.

(refer Fig. 1 & Fig. 2 on the next page)

Figure 1	JAZZ INSTRUMENTS LIMITED Statement of Financial Position 31 March 2021
	Assets
	Current assets:
	Cash			$800,000
	Marketable securities			200,000
	Accounts receivable	$2,600,000
	Less: Allowance for bad debts	300,000		2,300,000
	Inventory			5,500,000
	Total current assets			$8,800,000
	Fixed Assets:
	Plant and equipment, original cost	30,700,000
	Less: Accumulated depreciation	13,200,000
	Net plant and equipment			17,500,000
	Total assets			$25,900,000
	Liabilities and Stockholders Equity
	Current liabilities:
	Accounts payable				$6,600,000
	Accrued expenses				1,700,000
	Total current liabilities				8,300,000
	Long-term financing:
	Bonds payable				$6,120,000
}	Preferred stock				1,080,000
	Common equity Common stock				6,300,000
	Retained earnings				4,500,000
	Total common equity				10,800,000
	Total long-term financing				18,000,000
	Total liabilities and stockholders equity				$25,900,000

Figure 2 Cost of prior issues of debt and preferred stock	Security	Year of Issue	Amount	Coupon Rate
	Bond	2007	$1,120,000	6.1%
	Bond	2011	3,000,000	13.8
	Bond	2017	2,000,000	8.3
	Preferred stock	2012	600,000	12.0
	Preferred stock	2015	480,000	7.9

Required:

Q1. Determine the weighted average cost of capital based on using retained earnings in the capital structure. The percentage composition in the capital structure for bonds, preferred stock, and common equity should be based on the current capital structure of long-term financing as shown in Figure 1 (it adds up to $18 million). Common equity will represent 60 percent of financing throughout this case. (5 marks)

Q2. Recompute the weighted average cost of capital based on using new common stock in the capital structure. The weights remain the same, only common equity is now supplied by new common stock, rather than by retained earnings. After how much new financing will this increase in the cost of capital take place? Determine this by dividing retained earnings by the percent of common equity in the capital structure. (5 marks)

Q3. Is it possible that making investments with returns higher than the firms cost of capital will destroy value? Justify your answer. (4 marks)

Q4. Explain why the divisional cost of capital approach may cause problems if new projects are assigned to the wrong division. (5 marks)