It is January 2, 2005 and the President of Byfield Corporation has approached you with a problem. The president has uncovered three possible independent projects that the company could invest in. The president is wondering which of the projects the company should select. You inform the President, based on the knowledge gained in your corporate finance course, that she must first determine the company's cost of capital.
Based on this response, the President hires you to complete the analysis. You know that after calculating the company's cost of capital, you can make a decision regarding the available projects.
Byfield's capital structure, which is considered optimal, is as follows:
Bonds (10% coupon, due December 6, 2005) $ 3,800,000
Preferred equity ($20 stated value, 8.1% dividend rate) 1,400,000
Common shares (972,152 common shares outstanding) 1,000,000
Retained earnings 3,800,000
Total Capital $10,000,000
If Byfield were to issue a bond, it would have a life of 25 years. Byfield's current bonds were issued in 1985 for $998.25 per $1,000 of par. The bonds are now rated BBB (low) and are currently trading for $1,011.61 per
$1,000 of par. Magna Canada, also rated BBB (low), has a bond outstanding that has 20 years to run to maturity and has a coupon rate of 11% (paid semi-annually) This bond is currently trading for $1,238.47.
Byfield's underwriter has informed the company that for a bond with a 25 year maturity, the market would require a premium 30 basis points (0.30%) more than that provided on a 20 year bond issue with the same default risk. The new bond would be sold for $1,002 and issue costs on a new bond issue would be 2.2% of par. Byfield's tax rate is 20%.
Byfield's preferred shares are currently trading for $18.10. If Byfield issued new preferred shares, their underwriter has suggested that issue costs would be 2.7% of the $25 stated value of the new issue.
Byfield's most recent earnings available to common shareholders were $1,905,418 and the company paid common share dividends of $369,418 or $0.38 per share. Byfield's common shares are currently trading for $12.22 per share. You have been told that the company's earnings and dividends are expected to grow by 16% per year for the foreseeable future. For a sale of new common shares, issue costs would be 4.83% of the current share price.
The costs and the expected returns of the three projects Byfield is considering are presented below.
Expected
Project
Laser-based imaging machine Cost
$1,000,000 Return
13.4%
Thermal transfer colour printer $3,000,000 18.8%
Industrial application imaging machine $5,500,000 15.9%
Required:
a) Calculate Byfield's cost of capital. Which project(s) should Byfield accept? Explain.
b) In the phrase "cost of capital," what has a cost? Briefly explain why knowing the cost of capital is important for a company.