Baxter Metalworks Inc. has the following elements of capital. Debt: Baxter issued $1,000, 30-year bonds 10 years ago at a coupon rate of 9%. Five thousand bonds were sold at par. Similar bonds are now selling to yield 12%. Preferred stock: Twenty thousand shares of 10% preferred stock were sold five years ago at their $100 par value. Similar securities now yield 13%. Equity: The company was originally financed with the sale of 1 million shares of common stock at $10 a share. Accumulated retained earnings are currently $3 million. The stock is now selling at $12.50. Example 13.9 532 Part 3 Business Investment Decisions—Capital Budgeting Target capital structure: We won’t get into the reasoning behind the idea that one mix of capital components might be better than another until Chapter 14. For now, assume that Baxter has chosen the following target capital structure. Debt 20% Preferred stock 10 Equity 70 This means management attempts to keep the market values of the capital components reasonably close to these proportions over time as money is raised. Other information: • Baxter’s marginal income tax rate including federal and state rates is 40%. • Flotation costs average 10% in the sale of common and preferred stock. • Short-term treasury bills currently yield 7%. • An average stock currently yields 13.5%. • Baxter’s beta is 1.4. • The firm is expected to grow at 6.5% indefinitely. • The annual dividend paid last year was $1.10 per share. • Next year’s business plan includes earnings of $2 million, of which $1.4 million will be retained. Calculate Baxter’s capital structure, capital component weights, and its WACC before and after the retained earnings break.
Q-explain,in your own words, the steps involved in calculating the COST OF CAPITAL for a firm like Baxter. Starting with determining the proper weights of capital, component cost calculations and explanations and then the exhaustion point where retained earnings is used up and new stock needs to be issued.
In your explanations demonstrate what factors may be in play which will affect the steps involved as well as explaining the importance of the cost of capital in capital budgeting decision making.