Answers to Case Study Questions:

A.
1 What sources of capital should be included when you estimate
Colemans WACC?
- The sources of capital that should be included in estimating
Colemans WACC are long term debt, Preferred Stock, and Common
Equity.
2 Should the component costs be figured on a before-tax or an
after-tax basis?
- The component costs should be figured on an after-tax basis since
Payment of dividends and reinvestment which the stockholders are
primarily concerned with, are made with after-tax dollars.
3 Should the costs be historical (embedded) costs or new
(marginal) costs?
- The Cost of Capital is also known as the cost of raising additional
capital. Thus, relevant component costs are marginal costs rather than
historical costs.
B. What is the market interest rate on Colemans debt and its
component cost of debt?
x 30
0.12
1000(1+ ) +1000
2
2

( )

x
2

30

( )

1 1+
x
2

=1,153.72

r d =10

r d ( 1T )=10 (140 )=6

C.
1 What is the firms cost of preferred stock?
Rp=

Dp
Pp

(10 )( $ 100)
=0.0909
$ 111.10

2 Colemans preferred stock is riskier to investors than its debt,

yet the preferreds yield to investors is lower than the yield to
maturity on the debt. Does this suggest that you have made a
mistake? (Hint: Think about taxes)
- Preferred Dividends from Preferred Stocks are nontaxable. Thus,
preferred often has lower before-tax yield than before-tax yield on
debt issued. However, we should take note that the component cost
of debt is tax deductible. Thus the after-tax yield on preferred is
higher compared with the after-tax yield on debt issued by the same
company.
D.
1 Why is there a cost associated with retained earnings?
- Simply because theres an opportunity cost the return must not
exceed with what the stockholders could earn elsewhere.
2 What is Colemans estimated cost of common equity using the
CAPM approach?
RP
( m)
r s =r rf +
r s =0.07+(0.06)(1.2)
r s =0.14214.2
E. What is the estimated cost of common equity using the DCF
approach?
rs =

D1
+g
Po

rs =

D o ( 1+ g)
+g
Po

rs =

$ 4.19 (1.05)
+0.05
$ 50

rs =

$ 4.40
+0.05
$ 50

r s =0.088+0.05
r s =0.13813.8
F. What is the bond-yield-plus-risk-premium estimate for Colemans
cost of common equity?
r s =bond yield +risk premium
r s =10 +4
r s =14
G. What is your final estimate for
rs =

r s (capm )+r s( DCF)+ r s (bond yield plus premium)

3

rs =

13.8 +14 + 14.2

3

rs ?

r s =14
H. Explain in words why new common stock has a higher cost than
retained earnings?
- Due to Flotation Cost, Common Stock has a higher cost than retained
earning.
I.
1. What are the two approaches that can be used to adjust for
flotation costs?
- The two approaches that can be used to adjust for flotation costs are
1) include or add the flotation costs to the initial investment; and 2) adjust
cost of capital by including flotation costs.
2. Coleman estimates that if it issues new common stock, the
flotation cost will be 15%. Coleman incorporates the flotation costs

into the DCF approach. What is the estimated cost of newly issued
common stock, considering the flotation cost?
re=

D1
+g
Po (1F)

re=

D o (1+ g)
+g
Po (1F)

re=

$ 4.19 (1.05)
+ 0.05
$ 50 (10.15)

re=

$ 4.40
+ 0.05
$ 42.50

r e =0.153515.35

J. What is Colemans overall, or weighted average, cost of capital

WACC? Ignore flotation costs.
WACC=wd r d (1T ) + w p r p +w c r s
WACC=( 0.3 )( 0.10 )( 10.4 ) + ( 0.1 ) ( 0.09 ) + ( 0.6 ) ( 0.14 )
WACC=1.8 +0.9 + 8.4

WACC=11.1

K. What factors influence Colemans composite WACC?

- There are two factors that influence Colemans composite WACC, the
non-controllable factors and the controllable factors. The non-controllable
factors include the level of interest rates, stock prices, and tax rates; On the
other hand, Controllable factors include Capital Structure, Dividend Payout
Ratio and Capital Budgeting Rules.

L. Should the company use the composite WACC as the hurdle rate
for each of its projects? Explain.
- No, because every projects has different risks.