STAY SAFE PLASTICS COMPANY (SSPC Ltd.) Since its inception, SSPC Ltd. has been revolutionizing plastic and trying to do its part to save the environment. SSPC's founder, D. Maria, developed a biodegradable plastic that his company is marketing to manufacturing companies throughout the world. After operating as a private company for 7 years, SSPC Ltd. went public in 2020 and is listed on the New York Stock Exchange (NYSE). As the chief financial officer of a young company with lots of investment opportunities SSPC's CFO closely monitors the firm's cost of capital. The CFO keeps tabs on each of the individual costs of SSPC's three main financing sources: Long-term debt, preferred stock and common stock. The target capital structure for SSPC Ltd. is given by the weights in the following table: Source of capital Long term debt: Preferred Stock: Common Stock Equity, Weight 35% 25% 40% At the present time, SSPC can raise debt by selling 25 year bonds with a $1,000 par value and a 10.75% annual coupon interest rate. SSPC's corporate tax rate is 35% and its bonds generally require an average discount of $35 per bond and flotation costs of $22 per bond when being sold. SSPC's outstanding preferred stock pays a 9.25% dividend and has a $85 per share par value. The cost of issuing and selling additional preferred stock is expected to be $8.50 per share. Because SSPC is a young firm that requires lots of cash to grow it does not currently pay a dividend to common stockholders. To track the cost of common stock the CFO uses CAPM. The CFO and the firm's investment advisors believe that the appropriate risk free rate is 4.25% and that the market's expected return equals 13.50%. Using data from 2013 to 2020, SSPC's CFO estimates the firm's beta to be 1.35. Although SSPC's current target capital structure includes 25% preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to 60% long term and 40% common stock equity. If SSPC shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.45. Requirements: (a) (1) Assuming that no change in debt financing, what effect would a shift to a more highly leveraged capital structure consisting of 60% long- term debt, 0% preferred stock, and 40% common stock have on the risk premium for SSPC's common stock? What would be SSPC's new cost of common equity? (2) What would be SSPC's new weighted average cost of capital? (3) Which capital structure, the original one or this one, seems better? Why
