Pacific Coast Semiconductor (PCS) was founded in Palo Alto, California, in 1994. PCS started with a $500,000 investment from its founders and a $4.5 million design contract from a leading cellular telephone company. Since 1997, PCS has produced and marketed a broad range of computer chips for commercial use in the semiconductor market, primarily to makers of cellular telephones and laptop computers. Continued innovation in its memory and logic products, along with a rapid expansion in the market for these products, has resulted in high profitability and very rapid growth. By 1999, PCS's growing capital needs could no longer be met by internal funds, venture capital, and its ability to borrow, so the company went public. At the end of fiscal 2015, PCS shares were traded for about $58 per share in the over-the-counter market.

With the rapid growth in the scope and size of the business, financial decisions have become increasingly complex. Therefore, in late 2015, Ron Gingrich, a senior financial executive of a competing firm, was hired to head the finance group at PCS. Gingrich called upon Jane Porter, a recently hired MBA from nearby UC-Berkeley, to conduct a complete cost of capital analysis as of fiscal year-end 2015, and also to provide a critical evaluation of the current estimation procedures.

Porter assembled the following data:
(1) The bond quote on PCS's long-term, semi-annual bond as reported in the financial press is as follows:

Bonds Coupon Maturity Current Yield. Volume. Net Change

PCS 81⁄2. 2038. 8.8 37. + 1/8

(2) Quotes on PCS's common and preferred stock were as follows:

Stock Dividend Yield% PE Volume(100s). Hi-Lo. Close Net Change
PCS 1.20 2.8. 12 356 44.25 43.00 43.50 + 0.25

PCS pf. 2.50 7.8. ---- 87 32.33 31.75 32.25 - 0.12

(3) The one-year Treasury bill rate was 1.9%.

(4) PCS's federal-plus-state tax rate is 40 percent.

(5) The firm's last dividend (D0) was $1.20, and recent dividends have been growing at a rate of about 12.5%. Some analysts expect the recent growth rate to continue, while others expect it to go to zero as new competition enters the market, but the majority anticipate a growth rate of about 7% for the indefinite future. The company has 8.0 million shares outstanding.

(6) A prominent investment banking firm recently estimated that the market risk premium is 6 percent. PCS's beta, as measured by several analysts who follow the stock, is 1.35

(7) The market value optimal target capital structure calls for 15 percent long-term debt, 35 percent preferred stock, and 50 percent common equity.
Porter then answered the following set of questions to complete her assigned task and asked you to complete an independent verification of her results.

Questions:
(a) What is the estimate of the (pre-tax) cost of debt?
(b) What is the estimate of the required return on preferred stock?
(c) What is the estimated required return on common equity, using the CAPM approach?
(d) What is the dividend discount model estimate of the required return on common equity?
(e) What is the weighted average cost of capital?

Answer rating: 100% (QA)

a The cost of debt is the yield to maturity on PCSs longterm semiannual bonds which is 88 However th... View the full answer