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Cost of Capital

Cost of Capital

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Published by Jp Regis

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Published by: Jp Regis on Jul 10, 2011
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07/10/2011

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Chapter 9.Integrated Case ModelColeman Technologies is considering a major expansion program that has been proposed by thecompany’s information technology group. Before proceeding with the expansion, the company needs todevelop an estimate of its cost of capital. Assume that you are an assistant to Jerry Lehman, thefinancial vice-president. Your first task is to estimate Coleman’s cost of capital. Lehman has providedyou with the following data, which he believes may be relevant to your task:(1) The firm’s tax rate is 40 percent.(2) The current price of Coleman’s 12 percent coupon, semiannual payment, noncallable bonds wit h15 years remaining to maturity is $1,153.72. Coleman does not use short-term interest-bearing debt ona permanent basis.New bonds would be privately placed with no flotation cost.(3) The current price of the firm’s 10 percent, $100 par value, quarterly dividend, perpetual preferredstock is $111.10.(4) Coleman’s common stock is currently selling at $50 per share.Its last dividend (D0Coleman’scommon stock is currently selling at $50 per share.Its last dividend (D0) wasColeman’s common stock is currently selling at $50 per share.Its last dividend (D0) wasColeman’s common stock is currentlyselling at $50 per share.Its last dividend (D0) was) was$4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeablefuture.Coleman’s beta is 1.2, the yield on T-bonds is 7 percent, and the market risk premium isestimated to be 6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a4 percentage point risk premium.(5)Coleman’s target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity.To structure the task somewhat, Lehman has asked you to answer the following questions:(1) What sources of capital should be included when you estimate Coleman’s weighted average cost of capital (WACC)? The WACC is used primarily for making long-term capital investment decisions, i.e.,for capital budgeting.Thus, the WACC should include the types of capital used to pay for long-term assets, and this istypically long-term debt, preferred stock (if used), and common stock.Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accrued liabilities and (2)short-terminterest-bearing debt, such as notes payable.If the firm uses short-term interest-bearing debt to acquirefixedassets rather than just to finance working capital needs, then the WACC should include a short-termdebtcomponent.Noninterest-bearing debt is generally not included in the cost of capital estimate becausethesefunds are netted out when determining investment needs, that is, net operating rather than grossoperatingworking capital is included in capital expenditures.(2)Should the component costs be figured on a before-tax or an after-tax basis? Stockholders areconcerned primarily with those corporate cash flows that are available for their use, namely,those cash flows available to pay dividends or for reinvestment.Since dividends are paid from andreinvestment

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