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This case focuses on determination of the cost of capital for a firm. The student determines the cost of individual sources of financing, including long-term debt, preferred stock, and common stock. The cost of debt is adjusted for Eco Plastics’ 40% tax bracket. The company is considering a new financial structure, with the replacement of preferred stock financing with debt financing. Additional use of debt increases the common stockholders’ required rate of return. The student is asked to compare the two weighted average costs of capital and identify the better financial structure for Eco Plastics Company.
a. Cost of debt:
Proceeds from sale of $1,000 par value bond:
$1,000 − (average discount & floatation costs)
$1,000 − ($45 + $32) = $923
Subsequent payments: Interest payments ($1,000 × 0.105) + Par value
Before-tax cost of debt
N = 20, PV = $923, PMT = −105, FV = −1,000
Solve for I = 11.50%
After-tax cost of debt: ri = rd (1-T) = 11.5% (1−0.4) = 6.9%
b. Cost of preferred stock: rp = Dp ÷ Np
= (0.095 × $95) ÷ ($95 - $7)
= $9.02 ÷ $88
= 10.25%
c. Cost of common stock: rj = RF + [bj × (rm − RF)]
= 0.04 + [1.3 × (0.13 − 0.04)]
= 0.04 + [1.3 × 0.09]
= 0.04 + 0.1170
= 15.7%
d. Weighted average cost of capital: ra = (wi × ri) + (wp × rp) + (ws × rn)
= (0.30 × 0.069) + (0.20 × 0.1025) + (0.50 × 0.157)
= 0.0207 + 0.0205 + 0.785
= 0.1197, or about 12%
e. 1. Change in risk Premium: Change in beta × market risk premium = (1.5 − 1.3) × (0.13 − 0.04)
= 0.2 × 0.09 = 0.018
Shareholders require 1.8% more per year
New cost of common equity: rj = RF + [bj × (rm − RF)]
= 0.04 + [1.5 × (0.13 − 0.04)]
= 0.04 + [1.5 × 0.09]
= 0.04 + 0.1350
= 17.5%
Note: 17.5% − 15.7% = 1.8%
2. Revised weighted average cost of capital: ra= (wi x ri) + (ws x rn) = (0.50 × 0.069) + (0.50 × 0.175)
= 0.0345 + 0.0875
= 0.1220
3. Eco Plastics’ CFO should retain the cheaper current financial structure.
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Replacing preferred stock financing with debt financing results in more risk to the stockholders. The increase in stockholders’ required rate of return is more than offsets the advantage of using the low cost debt.
If Eco Plastics’ CFO were to revise the capital structure, share price would fall and shareholder wealth would not be maximized.
Eco Plastic Solution. (2016, May 14). Retrieved from https://studymoose.com/eco-plastic-solution-essay
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