999

Web site for case study ----------http://www.scribd.com/doc/21383691/Cost-of-Capital-Brigham-CaseSolution

Book er chapter 9 .
Since Coleman is a constant growth stock, the constant growth model can be used:/ +g$ 4 . 4 0 / $ 5 0 + 0 . 0 5 13.80%PART FWhat is the bond-yieldplus-risk-premium estimate for Colemans cost of common equity?The bond-yield-plus-riskpremium estimate is 14 percent:B o n d y i e l d + R i s k p r e m i u m 1 0 % + 4 % 14.00%Note that the risk premium required in this method is difficult to estimate, so this approach only provides acertain circumstances, produce unreasonable estimates.PART GM E T H O D E S T I M A T E C A P M 1 4 . 2 0 % D C F 1 3 . 8 0 % 14.00%A v e r a g e 1 4 . 0 0 % At this point, considerable judgment is required. If a method is deemed to be inferior due to the quality of itsinputs, then it might be given little weight or even disregarded. In our example, though, the three methodsproduced relatively close results, so we decided to use the average, 14 percent, as our estimate for Colemanscost of common equity.PART HExplain in words why new common stock has a higher percentage cost than retained earnings.The company is raising money in order to make an investment. The money has a cost, and this cost is basedprimarily on the investors required rate of return, considering risk and alternative investment opportunities.So, the new investment must provide a return at least equal to the investors opportunity cost.If the company raises capital by selling stock, the company doesnt get all of the money that investors put up.For example, if investors put up $100,000, and if they expect a 15 percent return on that $100,000, then$15,000 of profits must be generated. But if flotation costs are 20 percent ($20,000), then the company willreceive only $80,000 of the $100,000 investors put up. That $80,000 must then produce a $15,000 profit, or a$15/$80 = 18.75% rate of return versus a 15 percent return on equity raised as retained earnings.k =D P k
s 1 0 s

=k =k =k =k =ballpark estimate of k . It is useful, though, as a check on the DCF and CAPM estimates, which can, underWhat is your final estimate for k ?The following table summarizes the k estimates:k + RP
s s s s s s s d

PART I(1) What are two approaches that can be used to account for flotation costs?The first approach is to include the flotation costs as part of the project's up-front cost. This reduces theproject's estimated return. The second approach is to adjust the cost of capital to include flotation costs. Thisis most commonly done by incorporating flotation costs in the DCF model.(2) Coleman estimates that if it issues new common stock, the flotation cost will be 15 percent. Colemanincorporates the flotation costs into the DCF approach. What is the estimated cost of newly issuedcommon stock, taking into account the flotation cost?% F l o t a t i o n c o s t 1 5 % If flotation costs are expected to be 15% of the price, we need to find the after-flotation proceeds to be receivedfrom the stock.A F p r o c e e d s = P r i c e x ( 1 % F ) A F p r o c e e d s = $ 5 0 x ( 1 1 5 . 0 0 % ) A F p r o c e e d s = $ 4 2 . 5 0 The cost of new common stock can now be found./ A F p r o c e e d s + g $ 4 . 4 0 / $ 4 2 . 5 0 + 0 . 0 5 15.35%PART JWhat is Colemans overall, or weighted average, cost of capital (WACC)? Ignore flotation costs.Colemans WACC is 10.98 percent.3 0 % 6 % 1 0 % 9 . 0 0 % W A C C = 1 1 . 1 0 % 6 0 % 1 4 . 0 0 % PART K What factors influence Coleman's composite WACC?There are factors that the firm cannot control and those that they can control that influence WACC.Factors the firm cannot control (generally market conditions):level of interest ratestax ratesFactors the firm can control:Capital structure policyDividend policyInvestment policyk =D k =k =w A-T k w k w k
s 1 s s d d p p s s

PART LShould the company use the composite WACC as the hurdle rate for each of its projects? No. The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, theWACC only represents the hurdle rate for a typical project with average risk. Different projects havedifferent risks. The projects WACC should be adjusted to reflect the projects risk.PART MWhat are three types of project risk? How is each type of risk used?The three types of project risk are: (1) stand-alone risk, (2) corporate risk, and (3) market risk.Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employeesare more affected by corporate risk. Therefore, corporate risk is also relevant. Standalone risk is the easiesttype of risk to measure.Taking on a project with a high degree of either stand-alone or corporate risk will not necessarily affect thefirms market risk. However, if the project has highly uncertain returns, and if those returns are highlycorrelated with returns on the firms other assets and with most other assets in the economy, the project willhave a high degree of all types of risk.PART NColeman is interested in establishing a new division, which will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that stand-alonefirms involved in similar projects have on average the following characteristics:(1) Their capital structure is 40 percent debt and 60 percent common equity.(2) Their cost of debt is typically 12 percent.(3) The beta is 1.7.Given this information, what would your estimate be for the divisions cost of capital? Note that Coleman uses theCAPM to calculate the division's cost of capital.40%60%12%B e t a 1 . 7 +

*7 % + 1 . 7 * 6 % 17.20%4 0 % 7 . 2 0 % 6 0 % 1 7 . 2 0 % W A C C = 1 3 . 2 0 % The divisions WACC = 13.2% vs. the corporate WACC = 11.1%. The divisions market risk is greater thanthe firms average projects. Typical projects within this division would be accepted if their returns were above13.2 percent.w w k k =k (k -k )k =k =w A-T k w k
d s d S RF M RF S S d d s s