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Chapter 10: The Cost of Capital
d. (1) WACC using retained earnings
(2) WACC using new common stock
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Coleman Technologies Inc.
Cost of Capital
Coleman Technologies is considering a major expansion program that has
been proposed by the company’s information technology group. Before
proceeding with the expansion, the company must estimate its cost of capital.
Suppose you are an assistant to Jerry Lehman, the financial vice president.
Your first task is to estimate Coleman’s cost of capital. Lehman has provided
you with the following data, which he believes may be relevant to your task.
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To structure the task somewhat, Lehman has asked you to answer the
following questions.
A. (1) What sources of capital should be included when you estimate
Coleman’s WACC?
Answer: [Show S10–1 through S10–3 here.] The WACC is used primarily for
making long–term capital investment decisions, i.e., for capital
A. (2) Should the component costs be figured on a before-tax or an after-
tax basis?
Answer: [Show S10–4 here.] Stockholders are concerned primarily with
A. (3) Should the costs be historical (embedded) costs or new (marginal)
costs?
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Answer: [Show S10–5 and S10-6 here.] In financial management, the cost
B. What is the market interest rate on Coleman’s debt and its
component cost of debt?
Answer: [Show S10–7 through S10–11 here.] Coleman’s 12% bond with 15
years to maturity is currently selling for $1,153.72. Thus, its yield
to maturity is 10%:
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Optional Question
Should you use the nominal cost of debt or the effective annual cost?
Answer: Our 10% pre–tax estimate is the nominal cost of debt. Since the
C. (1) What is the firm’s cost of preferred stock?
Answer: [Show S10–12 and S10-13 here.] Since the preferred issue is
perpetual, its cost is estimated as follows:
C. (2) Coleman’s preferred stock is riskier to investors than its debt, yet
the preferred’s yield to investors is lower than the yield to maturity
on the debt. Does this suggest that you have made a mistake?
(Hint: Think about taxes.)
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Answer: [Show S10–14 and S10-15 here.] Corporate investors own most
preferred stock, so 70% of preferred dividends received by
D. (1) Why is there a cost associated with retained earnings?
Answer: [Show S10–16 and S10-17 here.] Coleman’s earnings can either be
retained and reinvested in the business or paid out as dividends. If
D. (2) What is Coleman’s estimated cost of common equity using the
CAPM approach?
Answer: [Show S10-18 and S10-19 here.] The CAPM estimate for Coleman’s
cost of common equity is 14.2%:
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E. What is the estimated cost of common equity using the DCF
approach?
Answer: [Show S10–20 and S10–21 here.] Since Coleman is a constant
F. What is the bond-yield-plus-risk-premium estimate for Coleman’s
cost of common equity?
Answer: [Show S10–22 here.] The bond–yield–plus–risk–premium estimate is
14%:
G. What is your final estimate for rs?
Answer: [Show S10–23 here.] The following table summarizes the rs
estimates:
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H. Explain in words why new common stock has a higher cost than
retained earnings.
Answer: [Show S10–24 here.] The company is raising money in order to make
an investment. The money has a cost, and this cost is based primarily
I. (1) What are two approaches that can be used to adjust for flotation
costs?
Answer: [Show S10–25 here.] The first approach is to include the flotation
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I. (2) Coleman estimates that if it issues new common stock, the flotation
cost will be 15%. Coleman incorporates the flotation costs into the
DCF approach. What is the estimated cost of newly issued common
stock, considering the flotation cost?
Answer: [Show S10–26 and S10–27 here.]
J. What is Coleman’s overall, or weighted average, cost of capital
WACC? Ignore flotation costs.
Answer: [Show S10–28 here.] Coleman’s WACC is 11.1%.
A-T
Capital Structure Component
Weights Costs = Product
K. What factors influence Coleman’s composite WACC?
Answer: [Show S10–29 here.] There are factors that the firm cannot control
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L. Should the company use the composite WACC as the hurdle rate for
each of its projects? Explain.