Purpose: The case gives the student additional opportunities to work with issues related to cost of capital. It focuses on the irrelevance of historical cost and the close relationship of retained earnings and new common stock in supplying equity capital. The concept of the marginal cost of capital is heavily stressed, and the use of the capital asset pricing model as an altemative to computing the cost of equity capital is also introduced. Please note that it is assumed that the historical costs of the capital structure approximate their market values. Relation to Text: The case should follow Chapter 11. Complexity: The case tends to be reasonably straightforward and requires about 1/2 hour. Berkire Instruments Al Hansen, the newly appointed vice important issue is the current cont of funds, prenident of finance of Berkshire Instruments, not the historical cort. The dealer suggested was eager to talk to his investment dealer that a comparable firm in the industry, in about future finmecing for the fim. One of terms of size and bond rating (BBB), Rollins AI's fint assignments was to determine the Instruments, had issued bonds a year and a fimm's cost of capital In assessing the weightis to use in cormputing the cost of capital, be valfe, and the bonds were currently selling for toouminedthecurrentbalancesheet,presented5890.Thebondshad20yearsremainingto in Figure 1. maturity. The dealer also observed that In their discusion, Al and his investment Rollings instrumeats had just issued preferred dealer detaruined that the earrent mix in the shares at 560 per share, and the preferred stock paid an annual dividend of $4.80. examined the current balance sheet, presented $890. The bonds had 20 years remaining to in Figure 1. maturity. The dealer also observed that In their discussion, Al and his investment Rollings Instruments had just issued preferred dealer determined that the current mix in the shares at $60 per share, and the preferred capital structure was very close to optimal and stock paid an annual dividend of $4.80. that Berkshire Instruments should continue In terms of cost of common equity, the with it in the future. (Our assumption here is dealer suggested that Al Hansen use the that the current historical capital structure dividend valuation model as a first approach approximates the market value capital to determining cost of equity. Based on that structure) Of some concern was the approach, Al observed that earnings were $3 appropriate cost to assign to each of the a share and that elements in the capital structure. Al Hansen 40 pereent would be paid out in dividends requested that his administrative assistant (D1). The current share price was $25. provide data on what the cost to issue debt and Dividends in the last four years had grown preferred stock had been in the past. The from 82 cents to the current value. information is provided in Figure 2 . The dealer indicated that the underwriting When Al got the data, he felt he was cost (flotation cost) on a preferred share issue making real progress toward determining the would be $2.60 per share and $2.00 per share cost of capital for the firm. However, his on common shares. Al Hansen further investment dealer indicated that he was going observed that his firm was in a 35 percent about the process in an incorrect mannil The marginal tax bracket. With all this information in hand, Al Hansen sat down to deternine his firm's cost of capital. He was a little confused about computing the firm's cost of common equity. He knew there were two different formulas: one: one for the cost of retained camings and one for the cost of new common stock. His investment dealer suggested that he follow the normally accepted approach used in determining the marginal cost of capital. First, determine the cost of capital for as large a capital structure as current retained earnings will support; then, determine the cost of capital based on exclusively using new common stock. BERKSHIRE INSTRUMENTS Statement of Financial Position December 31,20XX 1. Determine the weighted average cost of capital based on using retained camings in the capital structure. The percentage composition in the capital structure for bonds, preferred stock, and common equity should be based on the current capital structure of long-term financing as shown in Figure 1 (it adds up to $18 million). (Uice the historical costs on the assumption they approximate market values) Common equity will represent 60 percent of financing throughout this case. Use Rollins instruments data to calculate the cost of preferred shares and debt. 2. Recompute the weighted avenge cost of capital based on using new common ahares in the capital structure. The weights remain the same, only common equity is now supplied by new connmon ahares, rather than by retained earmings. After how much new financing will this increase in the cot of capital take place? Determine this by dividing retained earnings by the percent of common equity in the enpital struchure: 3. Assume the investment dealer also wishes to use the capital asset pricing model, as shown in Fornula 114 in the text, to compote the cost (required return) on common shares. Assume R=6 pereent, B is 1.25, and Rn is 13 percent. What is the value of K ? How does this compare to the vahe of K compited in question 1 ? Use financial calculator to find the yield of the bonds of Berkshire Instructments: 1/Y= Calculate the cost of debt: Kd=Y(Yield)(1T) Kd= Calculate the cost of preferred shares: Kp=(PpF)Dp Ke=PoD1+g D1 = Earnings per share Dividend payout ratio = = FV=PV(1+g)n Ke=PoD1+g D1=EarningspersharexDividendpayoutratio== FVg=PV(1+g)n== Ke= = Calculate the weighted cost of capital (using retained earnings): The cost of new common stock: Kn=(PoD1+g)PnPo Kn=(PoD1+g)PnPo Kn= = Calculate the waighted anct of ranital lueinn naw anmman eharal. edinigs to support capital structure: We can calculate the adequate retained earnings to support capital structure: X=%ofequityinthecapitalstructureRetainedearnings Where, X= size of capital structure that retained earnings will support x= Using CAPM to calculate the cost of common shares: K=Rf+B(RmRf)K== Analysis of K when compared to Ke from 1 : Using CAPM to calculate the cost of common shares: K=RfK+B(RmRf)== Analysis of K when compared to Ke from 1