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
Bonds………….........….... $ 6,120,000 34
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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$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
1
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
FV 1.463
PV $.82
The growth rate is approximately 10%.
$1.20
e
IF
e
D
K g
P
D
P
g
D
K g
P
= +
= ´ = ´ =
=
=
= = =
= + = 10% 4.80% 10% 14.80%
$25 + = + =
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
= +
–
= + = + =
–