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problem: Cost of capital 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 cost of capital. Suppose that you are an assistant to Jerry Lehman, the financial vice president. Your first task is to determine Coleman's cost of capital. Lehman has provided you with the following information, which he believes may be relevant to your task.

[A]     The firm's tax rate is 40%.

[B]     The current price of Coleman's 12% coupon, semiannual payment, no callable bonds with 15 years remaining to maturity is 1,153.72 dollar. Coleman does not use short-term interest bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

[C]      The current price of the firm's 10%, 100 dollar par value, quarterly dividend, perpetual preferred stock is $111.10.

[D]      Coleman's common stock is currently selling for 50 dollar per share. Its last dividend (Do) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Coleman's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond yield plus risk premium approach, the firm uses a risk premium of 4%.

[E]      Coleman's target capital structure is 30 percent debt, 10 percent preferred stock, and 60 percent common equity.

To structure the task somewhat, Lehman has asked you to answer the following problems.

[a] find out the firm's cost of preferred stock?

[b] Coleman's preferred stock is riskier to investors than its debt, yet the prefer red's yield to investors is lower than the yield to maturity on the debt. Do these suggest that you have made a mistake? [Clue: include taxes.]

Basic Finance, Finance

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