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 & his investment banker determined that the current mix in the capital structure was very close to optimal & 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 & preferred stock & 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 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 & bond rating (BAA), Rollins Instrument, had issued bonds a year & a half ago for 9.3 percent interest at a 1,000 dollars par value, & the bonds were currently selling for 890 dollars.  The bonds had 20 years remaining to maturity.  The banker also observed that Rollings Instruments had just issued preferred stock at $60 per share, & the preferred stock paid an annual dividend of 4.80 dollars.

In terms of cost of common equity, the banker suggested that Al Hansen use the divided valuation model as a first approach to determining cost of equity.  Based on that approach, Al observed that earnings were 3 dollars a share & that 40 percent would be paid out of dividends (D₁).  The current stock price was 25 dollars. Dividends in the last four years had grown from 82 cents to the current value.

The banker indicated that underwriting cost (flotation cost) on a preferred stock issue would be 2.60 dollars per share on common stock.  Al Hansen further observed that this 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 for the cost of retained earnings & one for the cost of new common stock.  His investment banker suggested 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 will support; then, determine the cost of capital based on exclusively using new common stock.

1)      find out the weighted average cost of capital based on using retained earnings in the capital structure.  The % composition in the capital structure for bonds, preferred stock & 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 compute the cost of preferred stock & debt.

K_e =            D₁

 ^_______  + g

                       P₀

K_e =      required rate of return

D₁ =     Divided at the end of the first year (or period)

P₀ =      Price of stock today

g   =     Constant growth rate in dividends

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.

1.         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)      Suppose the investment banker also wishes to use the capital asset pricing model to compute the cost [required return on common stock

CPAM [capital asset pricing model]

K_j = R_f  + B(K_m - R_f)

K_j =       required return on common stock

R_f  =     Risk-free rate of return; usually the current rate on Treasury bill securities

B  =      Beta coefficient.  The beta measures the historical volatility of an individual's stock's return relative to a stock market index.  A beta greater than 1 indicates volatility [price movements] than the market, while the reverse would be true for a beta less than 1.

K_m =     Return in the market as measured by an appropriate index

1.         Assume R_f  =    6 percent, B is 1.25, K_m is 13 percent.  What is the value of K_j?  & how does this compare to the value of K_e computed in problem 1?