Berkshire Instrument Case Study

Berkshire Instrument Case Study

FIN/486

Berkshire Instrument Case Study

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

WACC = Cost of debt * Proportion of debt + Cost of preferred stock * Proportion of preferred stock + Cost of equity * Proportion of equity

In order the find the weighted average cost of capital, you must first find the cost of the components of the capital structure and their proportion in the total capital. The bond pays 9.3% interest with a 20 year maturity and a par value of $1000, of which is being sold currently for $890.

Marginal tax rate = 35%

Interest = 9.3% * 1000

= $93

Cost of bonds = (1 – T) + (M – Vd ) 1/n = 93(1 – .35) + (1000 – 890) 1/20

(M + Vd) 1/2 (1000 + 890) 1/2

= 6.98%

Cost of preference shares:

Price = $60

Dividends = $4.8

Flotation cost = $2.6

Kp = Dp / P 0 – f =4.8 / 60 – 2.6=8.36%

Cost of equity:

Earnings = $3

Payout ratio = 40%

D1 = 40% * 3

= $1.20

Price = $25

Flotation cost = $2.0

Growth = (1.2 – 0.82) / 4 * 0.82

= 11.59%

Ke = D0(1+g) + g= 1.2 + 11.59%= 16.81%

P0 – f 25-2

WACC = 6.98% ( 6,120,000 ) + 8.36% ( 1,080,000 ) + 16.81% ( 10,800,000 )

18,000,00018,000,000 18,000,000

= 12.9608%= 12.96%

Proportion of Debt: The total amount of debt is 6,120,000 with the total long term capital of 18,000,000. Proportion of debt would be 6,120,000 / 18,000,000 = 34%.

Cost of Preferred Stock: We use the Rollins Instruments preferred stock. The preferred stock is a continuity with the cost being dividends/price. There would be a flotation cost of $2.60 when Berkshire issues preferred stock. The net price being used is 60 – 2.60 = $57.40. So, the cost of preferred stock is 4.80 / 57.40 = 8.36%.

Recompute the weighted average cost of capital based on using new common stock in the capital structure.

Old WACC = 6.98% ( 6,120,000 ) + 8.36% ( 1,080,000 ) + 16.81% ( 10,800,000 )

18,000,000 18,000,000 18,000,000

= 12.96%

Since new equity needs to be raised, the flotation cost will be added.

Flotation cost = $23 ($25 – $2)

Cost of equity = 1.20 / 23 + 10% = 15.20%

New WACC = 6.98% * 0.34 + 8.36% * 0.06 + 15.20% * 0.60

= 2.3732 + 0.0050 + 9.12

WACC = 11.49% or 11.50%

Retained earnings = $4,500,000

Capital structure = 60%

Capital cost increase = $7,500,000

The WACC that was calculated based on the retained earnings was more than the WACC that was calculated using new common stock. The preference would be to use the retained earnings method for future investments because of the fact that the lower cost of retained earnings are even lower than the costs of issuing new debt. It definitely looks as though Berkshire has enough retained earnings to manage the needs of future investments, instead of needing to issue new loans to pay for these future investments or expansion. From an investor standpoint, it is a good sign that Berkshire is able to retain enough earnings for these future investments or expansion. Companies that retain earnings in this way are more likely to get investors to invest in their company. It would be best for Berkshire to use their retained earnings to invest, as this would prove that they are able to create no extra debt. This also shows that they are able to be a self-maintaining company.

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