Since its inception, Eco Plastics Company has been revolutionizing plastic and trying to do its part to save the environment. Eoc s founder, Marion Cosby, developed a biodegradable plastic that her company is marketing to manufacturing companies throughout the southeastern United States. After operating as a private company for six years, Eco went public in 2009 and is listed on the Nasdaq stock exchange.
As the chief financial officer of a young company with lots of investment opportunities. Eco s CFO closely monitors the firm s cost of capital. The CEO keeps tabs on each of the individual cost of Eco s three main financing sources: long-term debt, preferred stock, and common stock. The target capital structure for ECO is given by the weights in the following table:
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Source of capital
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Weight
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Long-term debt
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30%
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Preferred stock
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20
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Common stock equity
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50
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Total
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100%
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As the present time, Eco can raise debt by selling 20-year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Eco s corporate tax rate is 40%, and its bonds generally require an average discount of $45 per bond and floatation cost of $32 per bound when being sold. Eco s outstanding preferred stock pays a 9% dividend and has a $95-per-shar par value. The cost of issuing and selling addional preferred stock is expected to be $7 per share. Because Eco is a young firm that requires lots of cash to grow it does not currently pay a dividend to common stock holders. To track the cost of common stock the CFO uses the capital asset pricing model (CAPM). The CFO and the firm s investment advisors believe that the appropriate risk-free rate is 4% and that the market s expected return equals 13%. Using data from 2009 through 2012, Eco s CFO estimates the firm s beta to be 1.3.
Although Eco s current target capital structure includes 20% preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to 50% long-term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expects its beta to increase to 1.5.
To Do
a. Calculate Eco s current after-tax cost of long-term debt.
b. Calculate Eco s current cost of preferred stock.
c. Calculate Eco s current cost of common stock.
d. Calculate Eco s current weighted average cost capital.
e. (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Eco s common stock? What would be Eco s new cost of common equity?
(2) What would be Eco s new weighted average cost of capital?
(3) Which capital structure-the original one or this one-seems better? Why?