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home / study / business / finance / questions and answers / since its inception, eco plastics company has been ... Question 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 six years, Eco went public in 2009 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 10.5% 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 $123 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 2009 to 2012, 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 debt 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
Explanation / Answer
ANS;
The first long term source of finance that we consider is the cost of long term debt, which is usually the cheapest of the long-term sources of finance. The majority of long term debt of large corporations is the result of issuing bonds.
Flotation cost
Companies that issue bonds have to take into account the flotation cost, which is the complete cost the company has to incur to issue and sell a security, such as common stock, preferred stock and bonds. This cost reduces the company%u2019s net proceeds from issuing security.
Flotation cost consists of underwriting and administrative costs. Underwriting costs are payment to investment bankers for their services and administrative costs are costs other than the underwriting costs of issuing bonds.
Finding the before-tax cost of long-term debt (rd)
To find the after-tax cost of long term debt, we first need to find the before-tax cost of long term debt (rd). As mentioned above, the majority of long term debts of large corporations are the result of issuing bonds. By using a financial calculator, we can find the before tax cost of a bond (cost of long-term debt).
THE CALCULATION FOLLOWS:
FV =
(future value of the bond which refers to its par value, which is also called the face value, and is usually $1,000)
PV =
the value of the bond today at which it is sold (after deducting the flotation cost)
PMT =
payment on the bond (for example, at 8% coupon interest rate a bond issuer will have to make annual payments of $80 if the par value is $1,000). Payments can also be made more frequently, such as semi-annually or even monthly, but in such a case we need to adjust the amount of payment and number of periods.
For example, if payment is made semi-annually, we will need to divide $80 by 2 and we will need to multiply number of periods by 2.
N =
Number of periods
Calculate I =
the cost of the bond (for the bond%u2019s issuer it is the cost to maturity of the cash flows, for the bond%u2019s holders it is the return they earn on buying and holding this bond to maturity). Within the context of our discussion, it is also the before-tax cost of long-term debt.
Note that if the net proceeds from the sale of the bond is the same as the face value of the bond than the before-tax cost of long-term debt will be equal to the coupon interest rate. For example, at 8% coupon interest rate, the par value of $1,000 and net proceeds of $1,000 (no flotation costs), the before-tax cost of long-term debt will equal 8%.
Finding the after-tax cost of long-term debt
After we found the before-tax cost of long term debt, we need to find the after-tax cost of long term debt. To do so all we need to do is to multiply the before-tax cost of long-term debt by (1-T), where T stands for the tax rate.
THEREFORE:
ri = rd * (1-T)
EXAMPLE:
If the before-tax cost of long term debt is 10% and tax rate is 28% then the calculation will be as follows:
Ri =10% * (1-.28)
Ri =10% * .72
Ri = 7.2%
Test yourself
You need to calculate the after-tax cost of a 30-year bond. The coupon interest rate is 10%, the par value is $1,000 and the bond is currently selling at $950.
SOLUTION:
PV: -950
FV: 1,000
PMT: 100
N: 30
I: 10.56%
Cost Of Capital - Cost Of Debt And Preferred Stock
Recall from Section 5 that companies sometimes finance their operations through debt in the form of bonds because bonds provide more flexible borrowing terms than banks. How much do companies pay for this debt?
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.
Calculating the Cost of Debt
Because companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment.
The after-tax cost of debt can be calculated as follows:
After-tax cost of debt = Rd (1-tc)
Note: Rd represents the cost to issue new debt, not the cost of the firm's existing debt.
Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt?
Answer:
Rd (1-tc) = 7% (1-0.40) = 4.2%
Calculating the Cost of Preferred Stock
As we discussed in section 6 of this walkthrough, preferred stocks straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate.
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