Eco Plastics Company: The target capital structure for ECO is given by the weigh

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Eco Plastics Company: The target capital structure for ECO is given by the weights in the following table:

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 bpnd 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 preferrerd 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 the capital asset price 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 2012 through 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 struture 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) Caluclate 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% perferred 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?

Source of Capital Weight Long-term debt 30 % Preferred stock 20 Common stock equity 50         Total 100 %

Explanation / Answer

a. Calculate Eco's current after-tax cost of long-term debt.cost of debt,
formula for current value of the bond =coupon payment * PVIFA (r, n)+ par value * PVIF(r,n)

here, coupon payment = 1000 * 10.5% = 105 r= we need to calculate n = bonds maturity = 20years and par value = $1000
current value of the bond = par value - discount if any - floating cost = 1000 - 45 - 32 = $923

923 =105PVIFA(r,20)+1000PVIF(r,20)

R= 11.5% after tax cost of debt= 11.5(1-0.4)= 6.9%

b. Calculate Eco's current cost of preferred stock

rp= Dp/ Np

here, rp =cost of preferred stock , Np = net proceeds = 95 - 7 = 8 and
Dp = dividend per share = 95 * 9% = 8.55

Threfore, rp = 8.5 / 88 = 9.72% is the cost of preferred stock .

c. Calculate Eco's current cost of common stock.

The current cost of common stock = 4%+ 1.3*(13%-4%) = 15.70%

d. Calculate Eco's current weighted average cost capital.

cost of debt , 105PVIFA(r,20)+1000PVIF(r,20)=923

R= 11.5% after tax cost of debt= 11.5(1-.4)= 6.9%

Cost of equity = 4+[1.3(13-4)]=15.7%

Cost of Preferred Stock = Dividend on Preferred/Price of Preferred/1-Flotation Costs 8.55/88= 9.72%

Therefore, WACC= 30%x6.9+20%x9.72+50%x15.7= 11.864%

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