FIN 305 Lecture Notes - Lecture 59: British Rail Class 59, Retained Earnings, Common Stock

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21 May 2019

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Cost of equity from new common stock (kn) The cost incurred by a company when new common stock is sold. ***ks is the opportunity cost of the common stockholders" funds. But common stockholders don"t receive a constant stream of dividends, so its harder to calculate than kp. Affect flotation costs and market price of security. We use one discount rate in our decision methods. The wacc combines the above costs of capital into one weighted average. A firm"s capital structure is the mixture of long-term funding sources that a firm uses to finance its assets. You have been asked to determine the cost of capital for gallagher corporation. Suppose that the company issues bonds with a before tax cost of 10%. Since interest payments are tax deductible, the true cost of the debt is the after tax cost. The company"s tax rate (state and federal combined) is 40%

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During the last few years, Agile technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, money costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to the VP of Finance. Your first task is to estimate Agile's cost of capital. You have been provided with the following data, which may be relevant to your task:

The firm's tax rate is 40 percent.

The current price of Agile's 14 percent coupon, semiannual payment, noncallable bonds with 16 years remaining to maturity is $1,316.05. Agile does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

The current price of the firm's 10.5 percent, $100 par value, perpetual preferred stock is $116.67. Agile would incur flotation costs of $2.00 per share on a new issue.

Agile's common stock is currently selling at $42.75 per share. Its last dividend (D₀) was $3.82, and dividends are expected to grow at a constant rate of 6 percent in the foreseeable future. Agile's beta is 1.26; the yield on t-bonds is 5 percent; and the market risk premium is estimated to be 5.6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 3 percentage point risk premium. Agile uses all three estimates of the cost of the common equity component in an equally weighted manner. New common stock would incur a flotation cost of 15%.

Agile's target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity.

The firm is forecasting retained earnings of $600,000 for the coming year.

Answer the following questions:

1. What is Agile's component cost of debt?

2. What is the firmâs cost of preferred stock?

3. What is Agile's estimated cost of retained earnings using the CAPM approach?

4. What is the estimated cost of retained earnings using the discounted cash flow (DCF) approach?

5. What is the bond-yield-plus-risk-premium estimate for Agile's cost of retained earnings?

6. What is your final estimate for Agileâs cost of retained earnings (k_s)?

7. What is Agile's overall, or weighted average, cost of capital (WACC) when retained earnings are used as the equity component?

8. What happens to the cost of equity when retained earnings are used up?

9. At what amount of new investment would Agile be forced to issue new common stock?

10. What is the WACC using new common stock?

Cost of new common stock

1. If a firm needs additional capital from equity sources once the retained earnings breakpoint is reached, it will have to raise the capital by issuing new common stock.

a. True: Firms will raise all the equity they can from retained earnings before issuing new common stock, because capital from retained earnings is cheaper than capital raised from issuing new common stock.
b. False: Firms raise capital from retained earnings only when they cannot issue new common stock due to market conditions outside of their control

2. Wooten Co. is considering a one-year project that requires an inital investment of $475,000; however, in raising capital, Wooten will incur an additional flotation cost of 2.0%. At the end of the year, the project is expected to produce a cash inflow of $595,000. Determine the rate of return that Wooten expects to earn on the project after flotation costs are taken into account.

a. 18.2%
b. 22.8%
c. 17.1%
d. 19.4%

3. Wooten Co. has a current stock price of $22.35 and is expected to pay a dividend of $2.45 at the end of next year. The company's growth rate is expected to remain constant at 5.2%. If flotation costs represent 5.0% of funds raised what is the flotation-adjusted cost of new common stock?

a. 16.2%
b. 13.4%
c. 16.7%
d. 14.2%

4. Wooten Co.'s addition to earnings for this year is expected to be $420,000. Its target capital structure consists of 50% debt, 5% preferred, and 45% equity. Determine Wooten's retained earnings breakpoint:

a. $886,666
b. $933,333
c. $1,166,666
d. $1,026,666

redfish429

The Horizon Corp. has 40 million shares of common stock with a current market price of $14.00 per share. They have $270 million in par value of long-term bonds outstanding that currently sell for $935 per $1,000 par value. The bonds have a coupon rate of 7.6% and a maturity of 20 years. Assume annual coupon payments. Horizon also has $120 million in par value of preferred stock with a current market price of $108 per $100 of par value. The dividend on this preferred stock is $8.80 per year. Flotation costs on new preferred stock will be about 3%.

The dividend on common stock in the most recent year (i.e. D₀) was $0.60. The firm has a growth rate of 4.5% that is expected to continue indefinitely into the future. On new common stock flotation costs would be about 8%. Flotation costs on new bonds would be negligible.

1. Assuming a combined state and federal marginal tax rate of 40%, estimate Horizonâs cost of capital. Calculate the WACC twice. The first time, assume they use retained earnings for any expansions, and the second time, assume that they use new common stock. The only thing that will change the second time you calculate the WACC is the cost of common equity.

2. Discuss, in general terms, how a firmâs investment policy can affect its WACC.

3. Explain how a companyâs capital structure policy could affect its WACC.

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FIN 305 Lecture Notes - Lecture 59: British Rail Class 59, Retained Earnings, Common Stock

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