Berkshire Instruments

Group No. 1 Alsim, Allan Patrick Belgica, Robie Escao, Ergo Galang, Roberto Villanueva, Jill Borlong, Li (Michael)
SPFINMAN / G05

Prof. Alan Jezrel Solomon, MBA

1. Determine the Weighted Average Cost of Capital (WACC) based on using retained earnings in the capital structure. In order to find the WACC, we need to find the cost of the components of the capital structure and their proportion in the total capital. Cost of Debt To find the cost of debt, we use the details of the bonds issued by Rollins Instruments. The bonds have 20 years to maturity, pay interest at 9.3%, have a par value of $1,000 and are currently selling for $890. The cost of debt is the yield to maturity (YTM) of the bonds. The YTM is the discount rate that will make the present value of interest and principal equal to the price today. The interest amount per year is $93 and the principal amount is $1,000. Using trial and error method of substituting different rates or by using the RATE function in excel, we derive the YTM as 10.65%. This is the before tax cost of debt. Since the interest amount is tax deductible, we use the after tax cost of debt in the WACC calculations. The tax rate is given as 35%. The after tax cost of debt is 10.65% X (1-0.35) = 6.92% Proportion of Debt The total amount of debt is 6,120,000 and the total long term capital is 18,000,000. The proportion of debt is 6,120,000/18,000,000 = 34% Cost of Preferred Stock We again us the Rollins Instruments preferred stock. The stock is currently trading at $60 and the annual dividends are $4.80. The preferred stock is a perpetuity and the cost is given by dividends/price. When Berkshire issues preferred stock, there would be floatation cost of $2.60. The net price to be used in the cost calculation is 60-2.60=$57.4. The cost of preferred stock is 4.80/57.4 = 8.36% Proportion of Preferred Stock The total amount of preferred stock is 1,080,000. The proportion of preferred stock is 1,080,000/18,000,000 = 6%. Cost of Retained Earnings We use the dividend discount model to get the cost of retained earnings. The formula is Cost of Equity = D1/MP + g Where D1 is the expected dividend MP is the market price g is the dividend growth rate D1 is given as 3X40% = $1.20 MP is $25 For g, we are given that the dividend has grown from $0.82 to $1.20 in four years. We use the compound interest formula to get the growth rate 1.20 = 0.82 X (1+g) ^4. This gives the value of g as 10% Cost of Equity = 1.20/25 + 10% = 14.8%

The proportion of equity is 10,080,000/18,000,000=60%. We do not use the floatation cost here, since retained earnings are internally generated and not to be raised. WACC = Cost of Debt X proportion of debt + Cost of Preferred Stock X Proportion of preferred stock + Cost of equity X proportion of equity WACC = 6.92%X0.34 + 8.36% X 0.06 + 14.8% X 0.60 WACC = 11.73% 2. Recompute WACC using new equity When new equity is to be raised, then there will be floatation cost. The net price will be $25-$2 the floatation cost = $23. Cost of Equity = 1.20/23 + 10% = 15.2% The new WACC is WACC = 6.92%X0.34 + 8.36% X 0.06 + 15.2% X 0.60 WACC = 11.97% Retained Earnings are $4,500,000 The proportion of equity in total capital structure is 60% The increase in cost of capital will take after 4,500,000/60%=$7,500,000 of new financing. 3. Using CAPM to calculate the cost of equity. The cost of equity is given as Cost of Equity = Risk free rate + (Market return risk free rate) X beta Give that Risk free rate =6% Market Return = 13% Beta = 1.25 Cost of Equity = 6% + (13%-6%) X 1.25 Cost of Equity = 14.75%. The value of Ke obtained in question 1 is 14.8% The cost of equity using CAPM is almost the same as the cost pf equity obtained through the dividend discount model.