Since its inception, Eco Plastics Company has been revolutionizing

By NYARANGI | Posted on May 11, 2014

Eco Plastics Company

Since its inception, Eco Plastics Company has been revolutionizingplastic and trying to do its part to save the environment. Ecosfounder, Marion Cosby, developed a biodegradable plastic that hercompany is marketing to manufacturing companies throughout thesoutheastern United States. After operating as a private companyfor six years, Eco went public in 2009 and is listed on the Nasdaqstock exchange.

As the chief financial officer of a young company with lots ofinvestment opportunities, Ecos CFO closely monitors the firmscost of capital. The CFO keeps tabs on each of the individual costsof Ecos three main financing sources: long-term debt, preferredstock, and common stock. The target capital structure for ECO isgiven by the weights in the following table:

Source of capital Weight

Long-term debt 30%

Preferred stock 20

Common stock equity 50

Total 100%

At the present time, Eco can raise debt by selling 20-year bondswith a $1,000 par value and a 10.5% annual coupon interest rate.Ecos corporate tax rate is 40%, and its bonds generally require anaverage discount of $45 per bond and flotation costs of $32 perbond when being sold. Ecos outstanding preferred stock pays a 9%dividend and has a $95-per-share par value. The cost of issuing andselling additional preferred stock is expected to be $7 per share.Because Eco is a young firm that requires lots of cash to grow itdoes not currently pay a dividend to common stock holders. To trackthe cost of common stock the CFO uses the capital asset pricingmodel (CAPM). The CFO and the firms investment advisors believethat the appropriate risk-free rate is 4% and that the marketsexpected return equals 13%. Using data from 2009 through 2012,Ecos CFO estimates the firms beta to be 1.3.

Although Ecos current target capital structure includes 20%preferred stock, the company is considering using debt financing toretire the outstanding preferred stock, thus shifting their targetcapital structure to 50% long-term debt and 50% common stock. IfEco shifts its capital mix from preferred stock to debt, itsfinancial advisors expect its beta to increase to 1.5.

TO DO

a. Calculate Ecos current after-tax cost of long-term debt.

b. Calculate Ecos current cost of preferred stock.

c. Calculate Ecos current cost of common stock.

d. Calculate Ecos current weighted average cost capital.

e. (1) Assuming that the debt financing costs do not change, whateffect would a

shift to a more highly leveraged capital structure consisting of50% long-term debt, 0% preferred stock, and 50% common stock haveon the risk premium for Ecos common stock? What would be Ecos newcost of common equity?

(2) What would be Ecos new weighted average cost of capital?

(3) Which capital structurethe original one or this oneseemsbetter? Why?