CASE STUDY

Since its inception, Green Corporation has been revolutionizing plastic and trying to do its part to save the environment. Greens founder, Marion Trump developed a biodegradable plastic that her company is marketing to manufacturing companies throughout the southern United States. After operating as private company for 6 years, Green went public in 2016 and is listed on NASDAQ stock exchange.

As Chief Financial Officer (CFO) of a young company with lots of investment opportunities, Greens CFO closely monitors the firms cost of capital. The CFO keeps tab to each of the individual costs of Greens three main financing sources: long term debt, preferred stock, and common stock. The target capital structure for Green is given by weights in the following table:

Source of capital	Weight (%)
Long Term Debt	30
Preferred Stock	20
Common Stock	50
Total	100

At the present time, Green can raise debt selling 20 years bond with a $1,000 par value and 10.5 percent annual coupon interest rate. Greens corporate tax is 40 percent and its bonds generally require an average discount of $45 per bond and flotation cost of $32 per bond when being sold. Greens outstanding preferred stock pays a 9 percent dividend and has $95 per share par value. The cost of issuing and selling additional preferred stock is expected to be $7 per share. Because Green is young firm that requires lots of cash to grow it does not currently pay dividend to common stock holders. To track the cost of common stock, CFO uses capital asset pricing model (CAPM). The CFO and firms investment advisor believe that the appropriate risk free rate is 6 percent and markets expected return equals 13 percent. Using data from 2016 through 2019, Greens CFO estimates the firms beta to be 1.2.

Although Greens current target capital structure include 20 percent preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to be 50 percent long term debt and 50 percent common stock. If Green shifts its capital mix from preferred stock to debt, its financial advisor expects its beta to increase to 1.7.

REQUIRED:

1. Calculate Greens current after-tax cost of long term debt.

(10 marks)

2. Calculate Greens current cost of preferred stock.

(5 marks)

3. Calculate Greens current cost of common stock.

(5 marks)

4. Calculate Greens current weighted average cost of capital.

(8 marks)

5. Assuming the debt financing cost remain unchanged,

1. What effect would shift to more highly leveraged capital structure consist of 50 percent long term debt, 0 percent preferred stock and 50 percent common stock have on the risk premium for Greens common stock?

(4 marks)

2. What would be Greens new cost of common equity?

(5 marks)

6. What would be Greens new weighted average cost of capital.

(8 marks)

7. Which capital structure-the current or proposed seems better? Why?

(5 marks)

-THE END-