FIN 401 The Weighted Average Cost of Capital

Case Summary

Coogly Company is attempting to identify its weighted average cost of capital for the coming year and has hired you to answer some questions they have about the process. They have asked you to present this information in a PowerPoint presentation to the company’s management team. The company would like for you to keep your presentation to approximately 10 slides and use the notes section in PowerPoint to clarify your point. Your presentation should address the following questions and offer a final recommendation to Coogly. Make sure you support your answers and clearly explain the advantages and disadvantages of utilizing the weighted average cost of capital methodology. Include at least one graph or chart in your presentation.

Cost.

• Coogly has outstanding preferred stock That pays a dividend of $4 per share and sells for $82 per share, with a floatation cost of $6 per share. What is the component cost for Coogly’s preferred stock? What are the advantages and disadvantages of using preferred stock in the capital structure?

(Argosy, 2015)

= 5.26%

Advantages.

(Equity Scholar, n.d.).

• Preferred status: Dividends must be paid on the preferred stock before they can be paid on the common stock. In a sale, liquidation or bankruptcy reorganization, the interests of the preferred holders usually come ahead of those of the common stock holders, but behind the debt holders.
  • Liquidity: Most preferred stocks trade on the NYSE or NASDAQ in round lots of 100 shares, making them easier to purchase than bonds, which trade in lots of $5,000 to $10,000.
  • Accumulation: Most, but not all, preferred stocks is cumulative, meaning if a full dividend is not paid each quarter, it accumulates indefinitely until paid. No common stock dividends can be paid until preferred dividends in arrears are paid. A Holder of cumulative preferred stocks may not receive dividends for a quarter or even years. Then, should the firm’s fortunes improve, the cumulative dividends will be paid. Some investors buy “broken” preferred stocks. These securities pay no dividends, but trade at big discounts to par/stated value; investors will hold them until the arrearage is cured. The shares normally rebound once dividend payments resume.
  • Tax advantages: Currently, preferred dividends are taxed at an appealing 15%, but that rate part of the Bush tax reduction, dividends of all types will be taxed as ordinary income if Congress does not act.

Disadvantages.

+ Growth Rate

• Minimal voting rights: Preferred owners can rarely elect directors. However, if the firm wants to issue senior securities, merge, or fundamentally alter the firm’s financial structure; the preferred owners usually have the right to vote on these matters.
  • Call ability: Almost all preferred stocks are callable at par/stated value at the issuer’s option, normally at a specified price after a specified time from issue date (usually five years). In the declining interest rate environment of recent years, many preferred stocks have been called, leaving holders with the challenge of replacing a high-dividend income stream. Companies are constantly looking to lower their cost of capital, and refinancing a high-cost preferred is one of the most logical ways to do this.
  • Interest rate risk: Like most fixed-income vehicles, existing preferred stocks will rise in price if interest rates fall and decline in price if interest rates rise. While there appears to be minimal evidence that rates are about to rise sharply, preferred owners should realize that risks increase as yields rise. Investors are best off buying preferred stocks in a stable or declining interest rate environment and avoiding them if rates are about to rise.
  • Credit risk: Deterioration in a company’s fundamentals could inhibit the ability to make preferred dividend payments. An issuer will eliminate a preferred dividend before it will default on its debt. Many preferred stocks are rated by Moody’s and/or Standard & Poor’s and investors should stick with preferred stocks that are rated investment grade (Baa/BBB) or better. A ratings downgrade is a sign that trouble may be brewing.
  • If the company issues new common stock, it will sell for $50 per share with a floatation cost of $9 per share. The last dividend paid was $3.80 and this dividend is expected to grow at a rate of 7% for the foreseeable future. What is the cost of new equity to the firm? What are the advantages and disadvantages of issuing new equity in the capital structure?

+ 7%

=16.27%

References

Argosy. (2015). Unit 4: Module 4: Capital Structure Choice (2 of 5). Argosy. Retrieved from:

http://myeclassonline.com/re/DotNextLaunch.asp?courseid=12842119&userid=12913634

Equity Scholar. (n.d.). The Advantages and Disadvantages of Preferred Stocks. Equity Scholar. Retrieved from:

http://www.equityscholar.com/library/the-advantages-and-disadvantages-of-preferred-stocks/