Not long ago, Boomtown Inc
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in whole or in part.
Integrative Case
Assume that you were recently hired as assistant to Je
y Lehman, financial VP of Coleman Technologies.
Your first task is to estimate Coleman’s cost of capital. Lehman has provided you with the following data,
which he believes is relevant to your task:
(1) The firm’s marginal tax rate is 40%.
(2) The cu
ent price of Coleman’s 12 % coupon, semiannual payment, noncallable bonds with 15
years remaining to maturity is $1, XXXXXXXXXXColeman does not use short-term interest-bearing debt
on a permanent basis. New bonds would be privately placed with no flotation cost.
(3) The cu
ent price of the firm’s 10%, $100 par value, quarterly dividend, perpetual prefe
ed stock
is $ XXXXXXXXXXColeman would incur flotation costs of $2 per share on a new issue.
(4) Coleman’s common stock is cu
ently selling at $50 per share. Its last dividend (D0) 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 Treasury 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 four
percentage-point risk premium.
(5) Up to $300,000 of new common stock can be sold at a flotation cost of 15%. Above $300,000,
the flotation cost would rise to 25%.
(6) Coleman’s target capital structure is 30% long-term debt, 10% prefe
ed stock, and 60%
common equity.
(7) The firm is forecasting retained earnings of $300,000 for the coming year.
To structure the task somewhat, Lehman has asked you to answer the following questions:
a. What is the market interest rate on Coleman’s debt and its component cost of debt?
XXXXXXXXXXWhat is the firm’s cost of prefe
ed stock?
(2) Coleman’s prefe
ed stock is riskier to investors than its debt, yet the yield to investors is lower
than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint:
Think about taxes.)
c XXXXXXXXXXWhat is Coleman’s estimated cost of retained earnings using the CAPM approach?
XXXXXXXXXXWhat is the estimated cost of retained earnings using the discounted cash flow (DCF) approach?
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in whole or in part.
(3) What is the bond-yield-plus-risk-premium estimate for Coleman’s cost of retained earnings?
(4) What is your final estimate for rs, Coleman’s cost of retained earnings?
d. What is Coleman’s cost for up to $300,000 of newly issued common stock, re1? What happens to the
cost of equity if Coleman sells more than $300,000 of new common stock?
e XXXXXXXXXXWhat is Coleman’s overall, or weighted average, cost of capital (WACC) when retained earnings
are used as the equity component?
(2) What is the WACC after retained earnings have been exhausted and Coleman uses up to
$300,000 of new common stock with a 15% flotation cost?
(3) What is the WACC if more than $300,000 of new common equity is sold?
Integrative Case