Cost of Capital - Berkshire Instruments Case

Berkshire Instruments
Al Hansen, the newly appointed vice president of finance of Berkshire Instruments, was eager to
talk to his investment banker about future financing for the firm. One of Al’s first assignments
was to determine the firm’s cost of capital. In assessing the weights to use in computing the cost
of capital, he examined the current balance sheet, presented in Figure 1.
In their discussion, Al and his investment banker determined that the current mix in the capital
structure was very close to optimal and that Berkshire Instruments should continue with it in the
future. Of some concern was the appropriate cost to assign to each of the elements in the capital
structure. Al Hansen requested that his administrative assistant provide data on what the cost to
issue debt and preferred stock had been in the past. The information is provided in Figure 2.
When Al got the data, he felt he was making real progress toward determining the cost of capital
for the firm. However, his investment banker indicated that he was going about the process in an
incorrect manner. The important issue is the current cost of funds, not the historical cost. The
banker suggested that a comparable firm in the industry, in terms of size and bond rating (Baa),
Rollins Instruments, had issued bonds a year and a half ago for 9.3 percent interest at a $1,000
par value, and the bonds were currently selling for $890. The bonds had 20 years remaining to
maturity. The banker also observed that Rollings Instruments had just issued preferred stock at
$60 per share, and the preferred stock paid an annual dividend of $4.80.
In terms of cost of common equity, the banker suggested that Al Hansen use the dividend
valuation model (DDM) as a first approach to determining cost of equity. Based on that approach,
Al observed that earnings were $3 a share and that 40 percent would be paid out in dividends
(D1). The current stock price was $25. Dividends in the last four years had grown from 82 cents
to the current value.
The banker indicated that the under-writing cost (flotation cost) on a preferred stock issue would
be $2.60 per share and $2.00 per share on common stock. Al Hansen further observed that his
firm was in a 35 percent marginal tax bracket.
With all this information in hand, Al Hansen sat down to determine his firm’s cost of capital. He
was a little confused about computing the firm’s cost of common equity. He knew there were two
different formulas: one: one for the cost of retained earnings and one for the cost of new common
stock. His investment banker suggested that he follow the normally accepted approach used in
determining the marginal cost of capital. First, determine the cost of capital for as large a capital
structure as current retained earnings will support; then, determine the cost of capital based on
exclusively using new common stock.
2
Figure 1 BERKSHIRE INSTRUMENTS

Statement of Financial Position
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 Stockholders’ 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 stockholders’ equity............................................................. $25,900,000
Figure 2
Cost of prior issues of debt and preferred stock
Coupon
Security Year of Issue Amount
Rate
Bond....................................................................................................................
2003 $1,120,000 6.1%
Bond....................................................................................................................
2007 3,000,000 13.8
Bond....................................................................................................................
2013 2,000,000 8.3
Preferred stock.....................................................................................................
2008 600,000 12.0
Preferred stock.....................................................................................................
2011 480,000 7.9
1. Determine the weighted average cost of capital based on using 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 of long-term financing as
shown in Figure 1 (it adds up to $18 million). Common equity will represent 60 percent of
financing throughout this case. Use Rollins instruments data to calculate the cost of preferred
stock and debt. (method: DDM – Discounted Deviden Model)
2. Re-compute the weighted average cost of capital based on using new common stock in the
capital structure. The weights remain the same, only common equity is now supplied by new
common stock, rather than by retained earnings. After how much new financing will this
increase in the cost of capital take place? Determine this by dividing retained earnings by the
percent of common equity in the capital structure.
3. Assume the investment banker also wishes to use the capital asset pricing model, (CAPM) to
compute the cost (required return) on common stock. Assume Rf = 6 percent, ß is 1.25, and Km is
13 percent. What is the value of Kj? How does this compare to the value of Ke computed in
question 1?
The difference between DDM and CAPM

Deviden based on Cash Flow then Deviden then Profit.
CAPM based on betha = where betha from difference price market – price stock / variance stock
All valuation use both method, and put weighted percentage between DDM and CAPM.
Cost of capital from damuderan book.
2nd meeting 6 april

FCFF (using the working capital)
FCFE (using equity)
Why 2 method? If the company is not paying deviden.
FCFF – emphasized on the working capital(constant WACC) - When the Cash Flow is stable
in a period of time
FCFE – fluctuating cash flow

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Berkshire Instruments

Figure 1 BERKSHIRE INSTRUMENTS

The difference between DDM and CAPM

Cost of capital from damuderan book.

2nd meeting 6 april

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