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13/5/2014
Eco Pl astics Company
Integrative Case 4: Eco Plastics Company
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 preferr preferred ed stock stock fi financi ancin ng with with debt fifinanci ancin ng. Addi Addition tional al use of debt in increases creases the the comm common stockh stockhol olders ders’’ 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 C ost of debt: Proceeds Proce eds from sale of $1,000 $1,00 0 par value value bond: $1,000 $1, 000 − (average discount & floatation costs) cos ts) $1,000 − ($45 + $32) = $923
Subsequent Subseq uent payments: payments: Interest payments payments ($1,000 ($1, 000 × 0.105) 0.1 05) + Par value value
BeforeBefore-tax tax cost of debt N = 20, PV = $923, PMT = −105, FV = −1,000 Solve Solve for I = 11.50% 11.50 % After-ta After-tax x cost of debt: ri = rd (1-T) (1- T) = 11.5% (1−0.4) = 6.9%
b. Cost of of preferr preferred ed stock: stock: rp = Dp 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) http://www.paper camp.com/pr i nt/Eco- Pl asti cs- Company/98706
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. 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.
