Determine the weighted average cost of capital based on using the amount of retained earnings in the capital structure.

Determine the weighted average cost of capital based on using the amount of retained earnings in the capital structure.

Subject: Business    / Finance    

Question

Case Study

FQP Corporation

In 2005 an entrepreneur named Thomas Allen started a small business as a sole proprietor in Arizona – a business that manufactured sensors for cameras that could be used in motion detection systems. The business was very successful and he decided to incorporate in 2007 under the name FQP Corporation. His long-term plan was to obtain public funding to support growth anticipated in about 8-9 years. In the meantime, he hired electrical engineers and a solid management team capable of building an organization that would enable the company to eventually go public. He thought his proprietary sensors and equipment could not be duplicate for a number of years. There was only one competitor in the market niche that had any market share. Besides, he anticipated growing the market himself, based on the increased focus and attention in the public arena on crime prevention, detection and surveillance using cameras with his sensors. He also was developing a host of other potential applications.

Allen had developed a good relationship with his investment banker Felicia Fundsgetter, and had just begun discussions with respect to obtaining additional capital required to position the company to go public in the next 3 to 5 years. These discussions also involved the chief financial officer (CFO), Mitch O. Dinero, who had brought up the issue of the appropriate capital structure (target capital structure) that FQP should consider. They both thought the current mix in the capital structure was close to optimal, and that only minor changes would be necessary. However, they would defer to the investment banker before they made any final decisions, and there were several tasks to be done before talking to her.

The initial work involved determining the firm’s cost of capital, and they would use the current balance sheet presented in Figure 1 to assess the weights of each of the capital components. Given that they were very close to the target capital structure, the difficult task would involve determining the appropriate cost to assign to each of the elements in the capital structure – debt, preferred stock, and common equity. And they thought the starting point was to gather data about the historical cost for issuing debt and preferred stock. That information is provided in Figure 2.


Figure 1

FQP Corporation

Statement of Financial Position: Balance Sheet

December 31, 2015

Assets
    

    

Current assets:
    

    

Cash
    

    

$ 400,000

Marketable securities
    

    

200,000

Accounts receivable
    

$ 2,600,000
    

Less: Allowance for bad debts
    

300,000
    

2,300,000

Inventory
    

    

5,500,000

Total current assets
    

    

$ 8,400,000

Fixed assets:
    

    

Plant and equipment, original cost
    

$ 30,700,000
    

Less: Accumulated depreciation
    

13,200,000
    

Net plant and equipment
    

    

17,500,000

Total assets
    

    

$ 25,900,000

Liabilities and Owners’ Equity
    

    

Current liabilities:
    

    

Accounts payable
    

    

$ 6,200,000

Accrued expenses
    

    

1,700,000

Total current liabilities
    

    

$ 7,900,000

Long-term financing
    

    

Bonds payable
    

    

$ 6,120,000

Preferred stock
    

    

1,080,000

Common stock

Retained earnings
    

{ Common equity
    

    

6,300,000

4,500,000

Total common equity
    

    

10,800,000

Total long-term financing
    

    

18,000,000

Total liabilities and owners’ equity
    

    

$ 25,900,000

    

    

Although they felt they were making real progress in determining the cost of capital for the firm, they were not confident about component costs that they had identified and decided a call to Felicia was in order to make sure they were on the right track, and they set up a conference call for the following day. During the conference call with her, they explained what had been accomplished and raised the issue about historical costs for each of the elements in the capital structure. She voiced a concern about using historical costs that were somewhat dated. She reported that she knew of a comparable firm in the industry (that needed to remain unnamed), in terms of size and bond rating (Baa), that had issued bonds a little over a year ago at a coupon rate of 9.3% at a $1000 par value, and further reported that the bonds were currently selling for $890 and had 20 years remaining to their maturity date. This firm more recently had issued preferred stock for $60 per share, and was paying a $4.80 dividend. She also indicated that underwriting a new issue of preferred stock would cost $2.60 per share (underwriting fee or flotation cost).

Figure 2 Historical issue cost of debt and preferred stock

Security
    

Year of Issue
    

Amount
    

Yield

Bond
    

2007
    

$ 1,120,000
    

6.1%

Bond
    

2010
    

3,000,000
    

13.8%

Bond
    

2012
    

2,000,000
    

8.3%

Preferred stock
    

2008
    

600,000
    

12.0%

Preferred stock
    

2011
    

480,000
    

7.9%

They finished the discussion about debt and preferred stock, and their attention naturally progressed to the question about how to determine the cost of common equity. The CFO suggested that one approach would be to use the dividend valuation model. In reviewing the financial statements, he noted that earnings were $3.00 a share and 40% of the earnings will be paid out in dividends (D1). Felicia also noted the dividends during the last four years had grown from $.82 per share to the current level, and the stock price was now $25 per share. She estimated the flotation costs for newly issued common stock would be $2.00 per share. Allen and the CFO thanked Felicia for the information and the assistance and told her they would get back with her after they had completed the preliminary computations.

There were several other factors that needed to be considered, and they relate to the following discussions:

    Whether to use the historical weights for the capital structure components, or try to estimate or compute new market weights.
    Should they use an estimated growth rate, compute the simple average growth rate, or use time value of money (TVM) concepts to determine a more accurate growth rate to use in cost of common equity calculations (dividend valuation model).

You have been chosen to assist the CFO in the analysis. Furthermore, several questions have been developed to help guide you, and they are listed below. However, there may be other issues that they have not thought of and that they want you to identify and address.

Case Questions (show all of your work)

1. Determine the weighted average cost of capital based on using the amount of retained earnings in the capital structure. The percentage composition in the capital structure for bonds, preferred stock, and common equity should be based on the current capital structure long-term financing as shown in Figure 1 (indicated as $18 million). Common equity will represent 60% of financing throughout the case, and the combined tax rate is 35%.

2. Recompute the weighted average cost using new common stock in the capital structure. Assume the weights remain the same; only common equity is now supplied by new common stock, rather than by retained earnings (debt and preferred stock costs remain the same).

3. The increase in the cost of capital will take place at a certain level of financing, where the cost of financing increases (known as the marginal cost of capital): what is this level of financing? Determine this by dividing retained earnings by the percent of common equity in the capital structure (as noted in Question 1).

4. Assume the investment banker also wishes to use the capital asset pricing model (CAPM, as shown on p. 370 in the text), to compute the cost (required return) on common stock. Assume the risk free rate (rRF) is 6%, beta for the firm is 1.25, and the market risk premium (RPM) is 7%. What is required rate of return for common equity using this method, and how does it compare to the required rate of return computed in Question 1 above?

 

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