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Berkshire Instruments Case 16
Cost of Capital
Purpose: The case gives the student additional opportunities to work with issues related to cost of capital.
It focuses on the irrelevance of historical cost and the close relationship of retained earnings and new
common stock in supplying equity capital. The concept of the marginal cost of capital is heavily stressed,
and the use of the capital asset pricing model as an alternative to computing the cost of equity capital is
also introduced.
Relation to Text: The case should follow Chapter 11.
Complexity: The case tends to be reasonably straightforward and requires about ½ hour.
Solutions
1. First determine the percentage composition in the capital structure.
Dollar amount Percentage composition
Then determine the aftertax cost of each component (for now assume common equity is in the form of
retained earnings).
Cost of Debt
(Yield) (1 )
d
K Y T= -
Annual Principal payment Price of the bond
interest
Approximate Number of years to maturity
payment
yield to
.6 (Price of the bond) .4 (Principle payment)
maturity ( ')Y
-
+
=
+
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of McGraw-Hill Education.
$1,000 - $890
$93 20
'.6 ($890) .4 ($1,000)
$110
$93 20
$534 $400
$93 $5.50 $98.50
' 10.55%
$934 $934
10.55% (.65)
6.86%
d
d
Y
Y
K
K
+
=+
+
=+
+
= = =
=
=
Cost of preferred stock
$4.80 $4.80 8.36%
$60 2.60 $57.40
P
P
P
D
KP F
=-
= =
-
Cost of common equity
(Retained earnings)
1
0
1
0
Earnings per share .4 $3.00 .4 $1.20
$25
The growth rate that will allow $.82 to grow to $1.20 over 4 years.
FV $1.20
e
D
K g
P
D
P
g
= +
= ´ = ´ =
=
=
of McGraw-Hill Education.
2. First compute the cost of new common stock.
1
0
$1.20 10% 5.22% 10% 15.22%
$25 $2
n
D
K g
P F
= +
-
= + = + =
-
Then recompute the cost of capital.
Cost
(aftertax) Weights
Weighted
Cost
Weighted average cost of capital..........................Kmc 11.96%
The size of the capital structure at which the cost of capital goes up is $7,500,000.
000,500,7$
60.
000,500,4$
structure capital in theequity common ofPercent
earnings Retained
3. Based on the capital asset pricing model, the cost of common stock (required return) is 14.75 percent.
This is quite close to the value derived using the dividend valuation model (Ke) in question 1 of 14.8
percent.
K = Rf + ß (Km – Rf)
6% + 1.25 (13% – 6%)
6% + 1.25 (7%) = 6% + 8.757 = 14.75%
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