Coogly Company Is Attempting To Identify Its Weighted Averag ✓ Solved
Coogly Company Is Attempting To Identify Its Weighted Average Cost Of
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. Company Information The capital structure for the firm will be maintained and is now 10% preferred stock, 30% debt, and 60% new common stock. No retained earnings are available. The marginal tax rate for the firm is 40%. 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? 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? The company will use new bonds for any capital project, according to the capital structure. These bonds will have a market and par value of $1000, with a coupon rate of 6% and a floatation cost of 7%. The bonds will mature in 20 years and no other debt will be used for any new investments. What is the cost of new debt? What are the advantages and disadvantages of issuing new debt in the capital structure? Given the component costs identified above and the capital structure for the firm, what is the weighted average cost of capital for Coogly? What are the advantages and disadvantages of using this method in the capital budgeting process? Format Introduction Issue A narrative Issue A calculation with answer highlighted Issue B narrative Issue B calculation with answer highlighted Continue with each question narrative Continue with each calculation with answer highlighted Conclusion Remember the slide must be at least 10 slides with notes. I would suggest setting the assignment up as follows: Cover slide A slide for each question A – D. You might put the calculations and answer on one slide and then use another slide to list advantages and disadvantages. You could discuss and explain these slides in the Notes of the Power Point. Offer a final recommendation on a slide. Support your work. Include one chart or graph on a slide. A references slide. A final ‘The End’ slide.
Sample Paper For Above instruction
Introduction
In this presentation, we will analyze the components of Coogly Company's capital structure to determine its weighted average cost of capital (WACC). Understanding WACC is vital for assessing investment opportunities and financing strategies. The company’s capital structure comprises preferred stock, debt, and equity, each with unique costs and implications.
Preferred Stock Component Cost
Narrative:
Preferred stock is a hybrid security, offering fixed dividends like debt but with equity-like features. Given Coogly's preferred stock pays a dividend of $4 per share, sells at $82, with a flotation cost of $6, we can calculate its component cost to the firm.
Calculation:
Cost of preferred stock (k_ps)
= Dividend / (Net proceeds per share)
= $4 / ($82 - $6)
= $4 / $76
≈ 0.0526 or 5.26%
Answer: The component cost of preferred stock is approximately 5.26%.
Advantages and Disadvantages of Preferred Stock
Advantages:
- Fixed dividends provide stability.
- No voting rights, thus avoiding dilution of control.
- Can be a cheaper alternative to debt if market conditions favor.
Disadvantages:
- Higher cost compared to debt due to lack of tax shield benefits.
- Dividends are not tax-deductible.
- Potentially stigmatize balance sheets as it resembles equity.
Cost of New Equity
Narrative:
For new common equity issuance, the dividend growth model (Gordon Growth Model) is used. The company’s last dividend was $3.80, expected to grow at 7%, with an issuance price of $50 and flotation costs of $9.
Calculation:
Cost of new equity (k_e)
= (D1 / P_net) + g
Where D1 = $3.80 * (1 + 0.07) = $4.066
P_net = $50 - $9 = $41
k_e = ($4.066 / $41) + 0.07 ≈ 0.0994 + 0.07 = 0.1694 or 16.94%
Answer: The cost of new equity is approximately 16.94%.
Advantages and Disadvantages of Issuing New Equity
Advantages:
- No obligation to repay dividends.
- Equity does not increase financial leverage.
- Can strengthen the firm’s equity base.
Disadvantages:
- Dilution of existing shareholders' ownership.
- Potentially high cost due to flotation and growth expectations.
- May signal firm riskiness to investors.
Cost of New Debt
Narrative:
The company plans to issue bonds with a coupon rate of 6%, par value of $1000, flotation costs of 7%, and a maturity of 20 years. These bonds are the sole debt used for investments.
Calculation:
Cost before tax (k_b)
= (Coupon payment + (Face value - Net proceeds) / years to maturity) / ((Face value + Net proceeds) / 2)
However, simplified for bonds:
k_b = [(Coupon / Net proceeds)] + (Annual amortization / Net proceeds)
But for clarity, the approximate yield to maturity (YTM) is used:
YTM ≈ Coupon rate + (Floatation costs / Face value)
= 6% + 7% = 13%
Adjusted for tax shield (since interest is tax-deductible):
k_d (after tax) = 13% * (1 - 0.40) = 7.8%
Answer: The after-tax cost of debt is approximately 7.8%.
Advantages and Disadvantages of Issuing New Debt
Advantages:
- Interest payments are tax-deductible, reducing taxable income.
- Generally cheaper than equity.
- Maintains control without dilution.
Disadvantages:
- Increases financial risk due to fixed obligations.
- Potential for default if cash flows decline.
- Bond covenants may restrict operational flexibility.
Weighted Average Cost of Capital
Narrative:
Using the component costs and cap structure proportions:
- Preferred stock: 10% weight, 5.26% cost.
- Debt: 30% weight, 7.8% after-tax cost.
- Equity: 60% weight, 16.94% cost.
Calculation:
WACC = (wd kd) + (wp kp) + (we * ke)
= (0.30 7.8%) + (0.10 5.26%) + (0.60 * 16.94%)
= 2.34% + 0.526% + 10.164% = 13.03%
Answer: The estimated WACC is approximately 13.03%.
Advantages and Disadvantages of Using WACC
Advantages:
- Provides a clear hurdle rate for project evaluation.
- Incorporates the company’s capital structure.
- Enhances consistent decision-making across projects.
Disadvantages:
- Assumes stable capital structure; less effective if significantly changing.
- Sensitive to estimation errors in component costs.
- May not reflect the risk of specific projects.
Conclusion and Final Recommendation
The computation of Coogly Company's WACC at approximately 13.03% offers a vital benchmark for investment decisions. Given that equity remains the dominant source of capital, the high cost reflects the risk premium investors require. While debt is relatively inexpensive after tax, over-reliance on debt could increase financial risk. The blend of preferred stock, debt, and equity aligns with the company’s strategic financial management, balancing risk and cost.
Recommendation:
It is advisable for Coogly to continue utilizing WACC for project valuation, but should regularly revisit component costs due to market fluctuations. Emphasizing debt within the prudent limits can help lower overall cost without disproportionately increasing financial risk. Additionally, exploring alternatives like hybrid securities or internal funding can further optimize the capital structure.
Chart/Graph Description
A pie chart illustrating the proportionate contribution of each component (preferred stock, debt, equity) to the overall capital structure along with their respective costs would visually demonstrate the weighted factors influencing the WACC.
References
- Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice. Cengage Learning.
- Ross, S. A., Westerfield, R., & Jaffe, J. (2020). Corporate Finance. McGraw-Hill Education.
- Damodaran, A. (2021). Applied Corporate Finance. John Wiley & Sons.
- Arnold, G. (2019). Corporate Financial Management. Pearson Education.
- Besley, S., & Brigham, E. F. (2018). Financial Management. Cengage Learning.
- Hillier, D., et al. (2020). Corporate Finance. McGraw-Hill Education.
- Gordon, M. J. (1990). The Cost of Capital, Corporation Finance and the Theory of Investment. The Review of Economics and Statistics.
- Myers, S. C. (2001). The Capital Structure Puzzle. Journal of Finance.
- Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review.
- Semmler, W. (2018). Financial Economics. Routledge.
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