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Component Cost of Capital - Cox Technologies

During the last few years, Cox Technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Jerry Lee, the financial vice-president. Your first task is to estimate Cox's cost of capital. Lee has provided you 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 Cox's 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Cox does not use short-term interest-bearing debt on a 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 preferred stock is $113.10. Cox would incur flotation costs of $2.00 per share on a new issue.

(4) Cox's common stock is currently selling at $50 per share. Its last dividend D0 was $4.19, and the dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. Cox's beta is 1.2, the yield on T-bonds is 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.

(5) Cox's target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity.

To structure the task somewhat, Lee has asked you to answer the following questions.

a. (1) What sources of capital should be included when you estimate Cox's weighted average cost of Capital (WACC)?
(2) Should the component costs be figured on a before-tax or an after-tax basis?
(3) Should the costs be historical (embedded) costs or new (marginal) costs?

b. What is the market interest rate on Cox's debt and its component cost of debt?

c. (1) What is the firm's cost of preferred stock?
(2) Cox's preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on debt. Does this suggest that you have made a mistake? (Hint: Think about taxes)

Solution Preview

a. (1) What sources of capital should be included when you estimate Cox'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 is typically Long term debt, preferred stock (if used) and common stock. Short term sources of capital consist of (1) spontaneous, non interest bearing liabilities such as Accounts Payable and accruals (2) Short Term interest bearing debt, such as Notes Payable. If the firm uses short term interest bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a short term debt component. Non interest bearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs, that is, net rather than ...

Solution Summary

The solution explains how to calculate the cost of various capital components in the capital structure.