Berkshire Instruments: Cost of Capital

To be honest, I don't even know where to start with this problem and would appreciate any help that you feel is allowed. At least something that could get me started and allow me to check my work when finish. Thank you for your help.

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Berkshire Instruments
Cost of Capital

A1 Hansen, the newly appointed vice president of finance of Berkshire Instruments, was eager to talk to his investment banker about future financing for the firm. One of Al's first assignments was to determine the firm's cost of capital. In assessing the weights to use in computing the cost of capital, he examined the current balance sheet, presented in Figure 1.

In their discussion, Al and his investment banker determined that the current mix in the capital. structure was very close to optimal and that Berkshire Instruments should continue with it in the future. Of some concern was the appropriate cost to assign to each of the elements in the capital structure. Al Hansen. requested that his administrative assistant provide data on what the cost to issue debt and preferred stock had been in the past. .The information is provided in Figure 2.

When Al got the data, he felt he was making real progress toward determining the cost of capital for the firm. However, his investment banker indicated that he was going about the process in an incorrect manner. The important issue is the current cost of the funds, not the historical cost. The banker suggested that a comparable firm in the industry, in terms of size and bond rating (Baa), Rollins Instruments, had issued bonds a year and a half ago for 9.3 percent interest at a $1,000 par value, and the bonds were currently selling for $890. The bonds had 20 years remaining to maturity. The banker also observed that Rollins Instruments had just issued preferred stock at $60 per share, and the preferred stock paid an annual dividend of $4.80.

In terms of cost of common equity, the banker suggested that A1 Hansen use the dividend valuation model as a first approach to determining cost of equity. Based on that approach, Al observed that earnings were $3 a share and that 40 percent would be paid out in dividends (D1). The current stock price was $25. Dividends in the last four years had grown from 82 cents to the current value.

The banker indicated that the underwriting cost (flotation cost) on a preferred stock issue would be $2.60 per share and $2.00 per share on common stock. Al Hansen further observed that his firm was in a 35 percent marginal tax bracket.

With all this information in hand, A1 Hansen sat down to determine his firm's cost of capital. He was a little confused about computing the firm's cost of common equity. He knew there were two different formulas: one for the cost of retained earnings and one for the cost of new common stock. His investment banker suggested that he follow the normally accepted approach used in determining the marginal cost of capital. First, determine the cost of capital for as large a capital structure as current retained earnings will support; then, determine the cost of capital based on exclusively using new common stock.

Figure 1

BERKSHIRE INSTRUMENTS
Statement of Financial Position
December 31, 2003

Assets

Current assets:
Cash $ 400,000
Marketable securities 200,000
Accounts receivable $2,600,000
Less: Allowance for bad debts 300,000 2,300,000
Inventory 5,500,000
Total current assets $ 8,400,000
Fixed assets:
Plant and equipment, original cost 30,700,000
Less: Accumulated depreciation 13,200,000
Net plant and equipment 17,500,000
Total assets $ 25,900,000
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 6,200,000
Accrued expense 1,700,000
Total current liabilities 7,900,000
Long-term financing:
Bonds payable 6,120,000
Preferred stock 1,080,000
Common stock } Common Equity 6,300,000
Retained earnings 4,500,000
Total common equity 10,800,000
Total long-term financing 18,000,000
Total liabilities and stockholders' equity $ 25,900,000

Figure 2

Security Year of Issue Amount Yield

Bond 1988 $ 1,120,000 6.1%
Bond 1992 3,000,000 13.8%
Bond 1998 2,000,000 8.3%
Preferred stock 1993 600,000 12.0%
Preferred stock 1996 480 7.9%
Cost of prior Issues
of debt and preferred
stock

Berkshire Instruments

Required 1. Determine the weighed average cost of capital based on using retained earnings
in the capital structure. The percentage composition in the capital structure for
bonds, preferred stock, and common equity should be based on the current capital
structure of long term financing as shown in Figure 1 (it adds up to $18 million).
Common equity will represent 60 percent of financing throughout this case.
2. Re-compute the weighed average cost of capital based on using new common stock
in the capital structure. The weights remain the same, only common equity is now
supplied by new common stock, rather than by retained earnings. After how much
new financing will this increase in the cost of capital take place? Determine this
by dividing retained earnings by the percent of common equity in the capital
structure.
3. Assume the investment banker also wishes to use the capital asset pricing model,
to compute the cost (required return) on common stock. Assume Krf = 6 percent, β is 1.25, and Km is 13 percent. What is the value of Ks? How does this compare to the value of Ks computed in question 1?