Al Hansen, the newly appointed vice president of finance of Berkshire Instruments, was eager to talk to his investment banker about future financing for the firm. One of Al’s first assignments was to determine the firm’s cost of capital. In assessing the weights to use in computing the cost of capital, he examined the current balance sheet, presented in Figure 1.
In their discussion, Al and his investment banker determined that the current mix in the capital structure was very close to optimal and that Berkshire Instruments should continue with it in the future. Of some concern was the appropriate cost to assign to each of the elements in the capital structure. Al Hansen requested that his administrative assistant provide data on what the cost to issue debt and preferred stock had been in the past. The information is provided in Figure 2.
When Al got the data, he felt he was making real progress toward determining the cost of capital for the firm. However, his investment banker indicated that he was going about the process in an incorrect manner. The important issue is the current cost of funds, not the historical cost. The banker suggested that a comparable firm in the industry, in terms of size and bond rating (Baa), Rollins Instruments, had issued bonds a year and a half ago for 9.3 percent interest at a $1,000 par value, and the bonds were currently selling for $890. The bonds had 20 years remaining to maturity. The banker also observed that Rollings Instruments had just issued preferred stock at $60 per share, and the preferred stock paid an annual dividend of $4.80.
In terms of cost of common equity, the banker suggested that Al Hansen use the dividend valuation model as a first approach to determining cost of equity. Based on that approach, Al observed that earnings were $3 a share and that
40 percent would be paid out in dividends (D1). The current stock price was $25. Dividends in the last four years had grown from 82 cents to the current value.
The banker indicated that the under-writing cost (flotation cost) on a preferred stock issue would be $2.60 per share and $2.00 per share on common stock. Al Hansen further observed that his firm was in a 35 percent marginal tax bracket.
With all this information in hand, Al Hansen sat down to determine his firm’s cost of capital. He was a little confused about computing the firm’s cost of common equity. He knew there were two different formulas: one: one for the cost of retained earnings and one for the cost of new common stock. His investment banker suggested that he follow the normally accepted approach used in determining the marginal cost of capital. First, determine the cost of capital for as large a capital structure as current retained earnings will support; then, determine the cost of capital based on exclusively using new common stock.
Figure 1 BERKSHIRE INSTRUMENTS
Statement of Financial Position
December 31, 2015
Accounts receivable$ 2,600,000
Less: Allowance for bad debts 300,0002,300,000
Total current assets$ 8,400,000
Plant and equipment, original cost30,700,000
Less: Accumulated depreciation 13,200,000
Net plant and equipment 17,500,000
Liabilities and Stockholders’ Equity
Accounts payable$ 6,200,000
Accrued expenses 1,700,000
Total current liabilities7,900,000
Bonds payable$ 6,120,000
Preferred stock 1,080,000
Common stock 6,300,000
Retained earnings 4,500,000
Total common equity 10,800,000
Total long-term financing 18,000,000
Total liabilities and stockholders’ equity$25,900,000
Cost of prior issues of debt and Security Year of Issue Amount Coupon Rate
preferred stock Bond 2003 $1,120,000 6.1%
Required 1. Determine the weighted average cost of capital based on using retained earnings 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). Common equity will represent 60 percent of financing throughout this case. Use Rollins instruments data to calculate the cost of preferred stock and debt.
2. Recompute the weighted average cost of capital based on using new common stock in the capital structure. The weights remain the same, only common equity is now supplied by new common stock, rather than by retained earnings. After how much new financing will this increase in the cost of capital take place? Determine this by dividing retained earnings by the percent of common equity in the capital structure.
3. Assume the investment banker also wishes to use the capital asset pricing model, to compute the cost (required return) on common stock. Assume Rf = 6 percent, ß is 1.25, and Km is 13 percent. What is the value of Kj? How does this compare to the value of Ke computed in question 1?
Clients' Reviews about Our Services
Client ID 45637
Brilliant services. I ordered a 4 page essay and it was delivered in less than 24hours with every detail intact!
Client ID 45783
Aceassignment is the way to go. The writers are humble and patient with clients. I know this after using the website for about an year
Client ID 45214
My writer did a brilliant job. Not only did she delivered the paper on time and it was superb as my professor granted me an A without any criticism
Client ID 45009
I was running late with my assignment. I run into aceassignment on google, placed my order and within less than 18 hours my page essay was delivered. Thank you Aceassignment.
Client ID 45870
I've been using Aceassignment for about 2 years. My writer always delivers quality work. Mind you whenever I request for a revision it's always done ASAP and free of charge
Client ID 44218
At first, I was scared and hesitant about using this website. Didn't know if they would deliver, but they assured me they will. And for sure they did. I will definitely continue to use their service!
Client ID 45622
Easy to use website. You simply give your essay's instructions, make payment and before you known it the paper is delivered to you.
Client ID 43964
Unlike other platforms, this website is quite cheap and the quality is high. I have them manage my whole class and everything has been smooth this far.
Client ID 41996
Thanks for the excellent job. Swift and on the subject, just the way I like it. The Support team was quite nice to me, helped me with the order placing process.
Client ID 47654
They are a marvel. I love their support team, they are so polite, it’s like speaking to a butler or something. Very pleasant people and good service of course.
Client ID 45670
Thank you for the help, I took my time and ordered a 14 days long essay. It came much earlier, around 7 days after I ordered it. Oh, and it was good, of course. I like the writer who did that, will definitely use again.
Client ID 22368
What I received was great. I forgot to mention in the instructions field that I needed reference page and by default, there was 0 in the number of references. I was surprised to see a full-fledged reference page in my paper with relevant citations. Bravo!
Client ID 46325
I was bombarding him with fine tuning and he handled it professionally. Thank you I will hire again the writer
Client ID 456820
Provided exceptional essay writing help in a short period of time. I plan to work with writer on many more projects!
Client ID 36890
Awesome paper in such a short amount of time. Was in a jam with another service who didn't deliver, but my writer did the job correctly. I will use her again to do my essays for sure!
Client ID 41427
Pretty good essay writer. I only made a couple of adjustments. She caught some instructions for the essay writing assignment that I didn't even notice, including them which was a pleasant surprise. Definitely recommend.
Client ID 45009
It was a very long paper, but the writer followed all the instructions, and she even finished the paper 5 days before the due date. Will write an essay with her again, thanks!
Client ID 36984
Writer was timely and proficient. I had to ask for a revision, but I got it back quickly with no other issues. Would use this essay writing service again.
Client ID 42960
Paper writing was prepared and submitted prior to the completed request date, and there were changes made quickly after I requested. This paper writer was accurate with numbers.
Client ID 31638
The first time I ordered here and it was a success. I received my order on time and according to my instructions. Thank you!
Client ID 46041
When I first discovered this website I was hesitant on whether they will deliver a plag free paper. The support team reassured me of their plagiarism policy. In deed they kept their word as the paper I got was authentic and plagiarism free.