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. Suppose you are an analyst with Coleman Technologies and you have been tasked with estimating the different components of cost of capital. The following data has been provided to you to assist with your task.

1.   The firm's tax rate is 25%.

2.  For the bond: a) The current price is $1,153.72. b) The coupon rate is 12%. c) The years to maturity is 15 years. d) New bonds would be privately placed with no flotation cost.

3.  For preferred stock: a) The current price is $111.10 b) The dividend rate is 10%. The par value is $100.  

4.  For common stock: a) The current price is $50 per share. b) The last dividend (D₀) was $4.19. Dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Ignore flotation costs.

5.   Coleman's target capital structure is 30% debt, 10% preferred stock, and 60% common equity.

Before Tax cost of debt =10% , after tax cost of debt= 7.5%, cost of preferred stock= 9%, common stock= 13.8%, WACC= 11.43%

Conduct a quick sensitivity analysis on the model you used to answer the previous questions. For the sensitivity analysis change (by either increasing or decreasing) the value of one of the factors which affects WACC. Describe what you changed and describe its impact on WACC. Also, hypothesize on what economic/political factors could drive such a change.

 

Answer:

Cost of Capital=represents the overall cost of financing to the firm . It is also known as hurdle rate, target rate , minimum acceptable rate and minimum return on investment. 

WACC=reflects the expected average future cost of funds over the long run.

            =found by weighing the cost of each specific type of capital by it's proportion in the firms capital structure.

WACC=(E/V * ke )+(D/V *kd) * (1-TR)

where: E = Market Value of Company Equity

             V=Total Value of company( equity + debt)

             D=Market Value of Company equity

             Ke=Cost of equity

             Kd=Cost of debt

Step-by-step explanation

SUMMARY of Given Information:

COLEMAN's TARGET                           COST(pretax)       COMPUTATION of WACC for target capital structure

capital structure

     Debt                       30%                           10%                               =30% x10%      x 75%  = 2.25%

     Preferred Stock    10%                            9%                                =10%   x9%       x 75%  =.675%

     Common Equity    60%                         13.8%                             =60%   x 13.8% x 75%  = 6.21%

                                                                                                                                                         9.135%  VS   11.43%

     Tax Rate                25%

ANALYSIS:

        =the difference between the current WACC of 11.43% from the target capital structure  WACC of 9.135%  decreased. Only the target capital structure is changed that resulted to the decrease in WACC where the cost of each structure is unchanged. The change in capital structure is produces lesser risk brought about by the market risks or firm specific risks.  The optimal capital structure for firms with cyclical industries should contain less debt than firms in stable industries. Having no debt in the firms capital structure will not minimize the firms WACC. Although debt financing is usually the cheapest component of capital, it cannot be used in excess because the financial risks may increase and thus drive up the cost of all sources of financing.

        =when most of the changes arises from cost of debt or equity, the resulting WACC will also change depending on the effect brought about by  the yield to maturity ,the growth in dividends as well as the flotation costs. 

       =marginal cost of capital recognizes that cost of capital does not stay constant as more funds are to be raised.