During the last few years, Agile technologies has been too constrained by the hi

Question

During the last few years, Agile technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, money 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 the VP of Finance. Your first task is to estimate Agile's cost of capital. You have been provided with the following data, which may be relevant to your task:

The firm's tax rate is 40 percent.

The current price of Agile's 14 percent coupon, semiannual payment, noncallable bonds with 16 years remaining to maturity is $1,316.05. Agile does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

The current price of the firm's 10.5 percent, $100 par value, perpetual preferred stock is $116.67. Agile would incur flotation costs of $2.00 per share on a new issue.

Agile's common stock is currently selling at $42.75 per share. Its last dividend (D0) was $3.82, and dividends are expected to grow at a constant rate of 6 percent in the foreseeable future. Agile's beta is 1.26; the yield on t-bonds is 5 percent; and the market risk premium is estimated to be 5.6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 3 percentage point risk premium. Agile uses all three estimates of the cost of the common equity component in an equally weighted manner. New common stock would incur a flotation cost of 15%.

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

The firm is forecasting retained earnings of $600,000 for the coming year.

Answer the following questions:

1.         What is Agile's component cost of debt?

2.         What is the firm’s cost of preferred stock?

3.         What is Agile's estimated cost of retained earnings using the CAPM approach?

4.         What is the estimated cost of retained earnings using the discounted cash flow (DCF) approach?

5.         What is the bond-yield-plus-risk-premium estimate for Agile's cost of retained earnings?

6.         What is your final estimate for Agile’s cost of retained earnings (ks)?

7.         What is Agile's overall, or weighted average, cost of capital (WACC) when retained earnings are used as the equity component?

8.         What happens to the cost of equity when retained earnings are used up?

9.         At what amount of new investment would Agile be forced to issue new common stock?

10.       What is the WACC using new common stock?

Explanation / Answer

Since, there are multiple parts of the question, the first five have been answered.

_________

Part 1)

The cost of debt can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Coupon Payment, PV = Current Selling Price and FV = Face Value.

_________

Here, Nper = 16*2 = 32, PMT = 1,000*14%*1/2 = $70, PV = $1,316.05 and FV = $1,000 [we use 2 since the bond is semi-annual]

Using these values in the above function/formula for Rate, we get,

Pre-Tax Cost of Debt = Rate(32,70,-1316.05,1000)*2 = 10%

After-Tax Cost of Debt = 10%*(1-40%) = 6%

________

Part 2)

The cost of preferred stock can be calculated with the use of following formula:

Cost of Preferred Stock = Annual Dividend/(Current Selling Price - Flotation Cost)*100

_________

Using the information provided in the question, we get,

Cost of Preferred Stock = (10.5%*100)/(116.67 - 2)*100 = 9.16%

________

Part 3)

The cost of retained earnings with the use of CAPM approach is calculated with the use of following formula:

Cost of Retained Earnings = Risk Free Rate + Beta*Market Risk Premium

_________

Using the information provided in the question, we get,

Cost of Retained Earnings = 5 + 1.26*5.6 = 12.056% or 12.06%

________

Part 4)

The cost of retained earnings with the use of DCF approachi is calculated with the use of following formula:

Cost of Retained Earnings = D0*(1+Growth Rate)/Current Price of Common Stock + Growth Rate

where D0 was last dividend.

_________

Using the information provided in the question, we get,

Cost of Retained Earnings = 3.82*(1+6%)/42.75 + 6% = 15.47%

________

Part 5)

The bond-yield-plus-risk-premium estimate for cost of retained earnings is calculated as follows:

Bond-Yield-Plus-Risk-Premium for Cost of Retained Earnings = Pre-Tax Cost of Debt (Bond Yield) + Risk Premium = 10% + 3% = 13%

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