ECO PLASTICS COMPANY Since its inception, Eco Plastics Company has been revoluti
ID: 2710679 • Letter: E
Question
ECO PLASTICS COMPANY
Since its 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
6 years, Eco went public in 2012 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: Weight
Long term debt: 30%
Preferred Stock: 20%
Common Stock Equity: 50%
Total 100%
At the present time, Eco can raise debt by selling 20 year bonds with a $1,000 par value and a 10.50% 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 stockholders. To track the cost of common stock the CFO uses 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 2012 to 2015, Eco's CFO estimates the firm's beta to be 1.3. Although Eco's 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 and 50% common stock equity. If Eco shifts its capital mix from preferred stock to debt, its financial advisors
expect its beta to increase to 1.5.
To Do:
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?
Explanation / Answer
(‘a) Current after Tax Cost of long term debt-
Face Value = $ 1000
Annual Interest = $105 ( 1000 x 10.5 %)
Maturity period = 20 Years
Net Proceeds = Face Value – Discount – Flotation Cost
Net Proceed (NP) = 1000-45-32
NP = $923
Kd (Before Tax ) = [interest + (FV-NP)/n]/(FV+NP)/2
Kd (Before Tax ) = [105 + (1000-923)/20]/(1000+923)/2
Kd (Before Tax ) = 11.32 %
Kd (After Tax ) = Kd (before Tax ) x (1- Tax Rate)
Kd (After Tax ) = 11.32 x (1-0.4)
Kd (After Tax ) = 6.79 %
(‘b) Current Cost of Preferred Stock
Par Value = $95
Annual dividend = $8.55
Net Proceed = Par Value – Issue Expenses
Net Proceed (NP) = 95-7
NP = $88
Kp = Annual Dividend / NP
Kp = 8.55/88
Kp = 9.72 %
(‘c) Current ost of Common Stock
Ke = Rf + x( Rm-Rf)
Ke = 4 + 1.3 x (13-4)
Ke = 15.7 %
(‘d) Current WACC
WACC = Wd x Kd (After Tax ) +( Wp x Kp ) + We Ke
WACC = (0.3 x 6.79 )+( 0.2 x 9.72)+ (0.5 x 15.7)
WACC = 11.83 %
(‘e) (1) Cost of Common Equity if Debt is increased
Ke = Rf + x( Rm-Rf)
Ke = 4 + 1.5 x (13-4)
Ke = 17.5 %
(‘2) New WACC
WACC = K=Wd x Kd (After Tax ) + We x Ke
WACC = (0.5 x 6.79 )+ 0.5 x 17.5
WACC = 12.15 %
(3) As WACC is lower in the earlier capital structure when debt was 30 % only. When debt is increased to 50 % , the expectation of common stock holder also increased as beta increased.
Hence the earlier capital structure is better one.
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