Coleman Technologies is considering a major expansion program that has

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. Assume that 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:
1. The firm’s tax rate is 40%.
2. The current price of Coleman’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Coleman does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
3. The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $111.10.
4. Coleman’s common stock is currently selling for $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Coleman’s beta is 1.2, the yield on Tbonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4%.
5. Coleman’s target capital structure is 30% debt, 10% preferred stock, and 60% common equity.
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?
(2) Should the component costs be figured on a before-tax or an after-tax basis?
(3) Should the costs be historical (embedded) costs or new (marginal) costs?
b. What is the market interest rate on Coleman’s debt and its component cost of debt?
c. (1) What is the firm’s cost of preferred stock?
(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.)
D. (1) Why is there a cost associated with retained earnings?
(2) What is Coleman’s estimated cost of common equity using the CAPM approach?
e. What is the estimated cost of common equity using the DCF approach?
f. What is the bond-yield-plus-risk-premium estimate for Coleman’s cost of common equity?
g. What is your final estimate for rs?
h. Explain in words why new common stock has a higher cost than retained earnings.
I. (1) What are two approaches that can be used to adjust for flotation costs?
(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?
j. What is Coleman’s overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.
k. What factors influence Coleman’s composite WACC?
l. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.
Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on...
Capital Structure
Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a...
Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...
Dividend
A dividend is a distribution of a portion of company’s earnings, decided and managed by the company’s board of directors, and paid to the shareholders. Dividends are given on the shares. It is a token reward paid to the shareholders for their...
Maturity
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest...

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