inception, Eco Plastics Company has been revolutionizing plastic and trying to
do its part to save the environment. Eco’s founder, Marion Cosby, developed a biodegradable
plastic that her company is marketing to manufacturing companies throughout the
southeastern United States. After operating as a private company for six years,
Eco went public in 2009 and is listed on the Nasdaq stock exchange.
As the chief financial
officer of a young company with lots of investment opportunities, Eco’s CFO
closely monitors the firm’s cost of capital. The CFO keeps tabs on each of the
individual costs of Eco’s three main financing sources: long-term debt,
preferred stock, and common stock. The target capital structure for ECO is
given by the weights in the following table:
Source of capital
Long-term debt 30%
Preferred stock 20
Common stock equity 50
At the present
time, Eco can raise debt by selling 20-year bonds with a $1,000 par value and a
10.5% annual coupon interest rate. Eco’s corporate tax rate is 40%, and its
bonds generally require an average discount of $45 per bond and flotation costs
of $32 per bond when being sold. Eco’s outstanding preferred stock pays a 9%
dividend and has a $95-per-share par value. The cost of issuing and selling
additional preferred stock is expected to be $7 per share. Because Eco is a
young firm that requires lots of cash to grow it does not currently pay a
dividend to common stock holders. To track the cost of common stock the CFO
uses the capital asset pricing model (CAPM). The CFO and the firm’s investment
advisors believe that the appropriate risk-free rate is 4% and that the
market’s expected return equals 13%. Using data from 2009 through 2012, Eco’s
CFO estimates the firm’s beta to be 1.3.
current target capital structure includes 20% preferred stock, the company is
considering using debt financing to retire the outstanding preferred stock,
thus shifting their target capital structure to 50% long-term debt and 50%
common stock. If Eco shifts its capital mix from preferred stock to debt, its
financial advisors expect its beta to increase to 1.5.
a. Calculate Eco’s current
after-tax cost of long-term debt.
b. Calculate Eco’s current cost
of preferred stock.
c. Calculate Eco’s current cost
of common stock.
d. Calculate Eco’s current
weighted average cost capital.
e. (1) Assuming that the debt
financing costs do not change, what effect would a
shift to a more highly leveraged
capital structure consisting of 50% long-term debt, 0% preferred stock, and 50%
common stock have on the risk premium for Eco’s common stock? What would be
Eco’s new cost of common equity?
(2) What would be Eco’s new
weighted average cost of capital?
(3) Which capital structure—the
original one or this one—seems better? Why?