Table 1

Illinois Bio Technologies, Inc.

Balance Sheet for the Year Ended December 31, 2013

(In Millions of Dollars)

Cash and marketable securities	$	7.6	Account payable	$	5.7
Accounts receivable		39.6	Accrual		7.5
Inventory	9.1		Notes payable	1.9
Current assets	$ 56.3		Current Liabilities	$ 15.1
			Long-term debt		61.2
Net fixed assets		114.5	Preferred stock		15.0
			Common stock	79.5
Total assets	170.8		Total claims	170.8

To begin, Owen reviewed IBTECH's 2013 balance sheet, which is shown in Table 1. Next, she assembled the following data:

IBTECH's long-term debt consists of 9.5 percent coupon, semiannual payment bonds with fifteen year remaining to maturity. The bonds last traded at a price of $891 per $1,000 par value bond. The bonds are not callable and they are rated BBB.

The founders have an aversion to short-term debt, so the firm uses such debt only to fund cyclical working capital needs.

IBTECH' federal-plus-state tax rate is 40 percent.

The companys preferred stock pays a dividend of $2.50 per quarter and has a par value of $100. It is non-callable and perpetual, and it is traded in over-the-counter market at a current price of $104 per share. A flotation cost of $2 per share would be required on a new issue of preferred stock.

The firm's last dividend (D₀) was $1.09, and dividends are expected to grow at about a 10 percent rate in the foreseeable future. Some analyst expect the company' recent growth rate to continue, other expect it to go to zero as new competition enter the market, but the majority anticipate that a growth rate of about 10 percent will continue indefinitely.

An important minority of analyst have noted that over the last few years, the company has had a 14 percent average return on equity (ROE) and has paid out about 25 percent of its net income as dividends. They believe the firm' expected future growth rate, g should be based on this information and used to estimate the cost of capital.

The firm's per share dividend payment over the past five year has been a follow

Year	Dividend
2008	0.72
2009	0.75
2010	0.85
2011	1.00
2012	1.09

IBTECHs common stock now sells at a price of about $25 per share. The company has 5 million common shares outstanding.

The current yield on long-term T-bonds is 8 percent, and a prominent investment-banking firm has recently estimated that the market risk premium is six percentage points over Treasury bond. The firm' historical beta, as measured by several analysts who follow the stock, is 1.2.

The required rate of return on an average (A-rated) company's long-term debt is 10 percent.

IBTECH is forecasting retained earnings of $1,800,000 and depreciation of 4,500,000 for the coming year.

IBTECH's investment banker believes that a new common tack issue would involve total flotation costs - including underwriting costs, market pressure from increased supply, and market pressure from negative signaling effect- of 30 percent.

The market value target capital structure call for 30 percent long-term debt, 10 percent preferred stock, and 60 percent common stock.

Now assume that you were recently hired as Julie Owens assistant, and she has given you the task of helping her develop the firm's cost of capital. You will also have to meet with Gary Hayes and, possibly, with the president and the full board of directors (including the Kean University Professor) to answer any question they might have. With this in mind, Owens wrote up the following questions to get you started with your analysis. Answer them, but keep in mind that you could be asked further questions about your answer, so be sure you understand the logic behind any formula or calculation you use. In particular, be aware of potential conceptual or empirical problems that might exist.

QUESTIONS

1. Sources of capital:

a. What specific items of capital should be included in IBTECH's estimated weighted average cost of capital (W ACC)? Should before-tax or after-tax value be used? Should historical (embedded) or new (marginal) values be used? Why?

2. Capital Structure:

a. What are IBTECH's book value weights of debt, preferred tock, and common stock? (Hint: Consider only long-term source of capital.)

b. What are IBTECH's market value weights of debt, preferred stock, and common stock?

c. Should book value or market value weights be used when calculating the firm' weighted average cost of capital? Why?

d. Should current weights or target capital structure weights be used when calculating the firm' weighted average cost of capital? Why?

3. Cost of debt:

a. What is your estimate of IBTECHs cost of debt?

b. Should flotation costs be included in the component cost of debt calculation? Explain.

c. Should the nominal cost of debt or the effective annual rate be used? Explain.

d. How valid is an estimate of the cost of debt based on 15-year bonds if the firm normally issues 30-year long-term debt? If you believe the estimate is not valid, what could be done to make the 15-year cost a better proxy for the 30-year cost? (Hint: Think about the yield curve.)

e. Suppose IBTECH's outstanding debt had not been recently traded; what other methods could be used to estimate the cost of debt?

4. Cost of preferred stock:

a. What is your estimate of the cost of preferred stock? (assume that the company will issue new preferred stock)

b. Now suppose IBTECH's preferred stock had a mandatory redemption provision, which specified that the firm must redeem the issue in five year at a price of $110 per share. What would IBTECH's cost of preferred be in this situation? (In fact, IBTECHs preferred does not have such a provision, so ignore this question when working the remainder of the case.)

5. Cost of retained earnings using CAPM:

a. Why is there a cost associated with retained earnings?

b. What is IBTECH's estimated cost of retained earning using the CAPM approach?

c. Why might one consider the T-bond rate to be a better estimate of the risk-free rate than the T-bill rate? Can you think of an argument that would favor the use of the T-bill rate?

d. How can IBTECH obtain a market risk premium for use in a CAPM cost-of-equity calculation? Discuss both the possibility of obtaining an estimate from some other organization and also the ways in which IBTECH could calculate a market risk premium in-house.

e. Calculate the cost of retained earnings (r_s ) using CAPM

6. Cost of retained earnings using DCF:

a. Suppose IBTECH, over the last few years, has had a 14 percent average return on equity (ROE) and has paid out about 25 percent of its net income as dividend. Under what condition could this information be used to help estimate the firm' expected future growth rate, g? Calculate g using this approach

b. The firm's per share dividend payment over the past five years has been as follow:

Year	Dividend
2009	0.72
2010	0.75
2011	0.85
2012	1.00
2013	1.09

What was the firm' historical dividend growth rate using the point-to-point method? Using linear regression?

c. Use the discounted cash flow (DCF) method to obtain an estimate of IBTECHs cost of retained earnings (r_s).

7. Use the bond-yield-plus-risk-premium method to estimate IBTECH's cost of retained earnings (r_s).

8. What is your final estimate for r_s? Explain how you weighted the estimate of the three methods.

9. What is your estimate of IBTECH's cost of new common stock, r_e? What are some potential weaknesses in the procedure you used to obtain this estimate?

10. Construct IBTECH's marginal cost of capital (MCC) schedule:

a. How large could the company's capital budget be before it is forced to sell new common stock? Ignore depreciation at this point.

b. Would the MCC schedule remain constant beyond the retained earnings break point, no matter how much new capital it raised? Explain. Again, ignore depreciation.

c. How does depreciation affect the MCC schedule? If depreciation were simply ignored, would this affect the acceptability of proposed capital projects? Explain.

11. Should the corporate cost of capital as developed above be used by both division, and for all projects within each division? If not, what type of adjustment should be made?

Illinois Bio Technologies (continued)

After calculating the Marginal Cost of Capital, the financial vice president of Illinois Bio Technologies (IBTECH) asks Julie Owens, IBTECH's treasurer, to determinate the optimal capital budget for the coming year. Different units, across the company, have presented the following projects:

Project	Cost	MIRR
A	600	14.00%
B	800	13.00%
C	800	16.50%
D	550	14.57%
E	750	15.75%
F	400	12.00%

Owens has turned the task to you and has prepared the following additional questions:

12. What is the main advantage of using MIRR (instead of IRR) in the calculation of Optimal Capital Budget? (Hint: remember that IBTECH has two divisions, one with high business risk and other with low business risk)

13. Graph the Marginal Cost of Capital (see question 10) along with the Investment Opportunity Set (IOS).

a. What is the optimal Capital Budget?

b. Which projects should be accepted and which ones should be rejected? Explain