Pickerington Communications Inc. Has Developed A Powerful

Pickerington Communications Inc Pci Has Developed A Powerful Server

Pickerington Communications Inc. (PCI) has developed a powerful server for its internet activities. The company's capital structure comprises 30% debt, 10% preferred stock, and 60% common stock. PCI’s tax rate is 25%, and it is expected that earnings and dividends will grow at a constant rate of 6%. The company paid a dividend of $3.70 per share last year (D0), and its current stock price is $60 per share. The yield to maturity on long-term debt is 9%. The company can issue new preferred stock at $100 per share with a dividend of $9 and flotation costs of $5 per share. The risk-free rate (10-year Treasury bond yield) is 6%, the market risk premium is 5%, and PCI’s beta is 1.3. Future long-term bonds are expected to have a YTM of 13% with a coupon rate of 10%, but the company is uncertain about future tax rates, which could be 25%, 20%, or 35%. The company plans to finance common equity internally by reinvesting earnings.

Paper For Above instruction

Introduction

Understanding a company's capital structure and the associated costs of different financing components is crucial for effective financial management. This paper analyzes the major components of PCI's capital structure, computes their respective costs, and determines the overall weighted average cost of capital (WACC). Additionally, the paper explores the effects of varying tax rates on the after-tax cost of debt and discusses management strategies to optimize the company's cost of capital.

Major Capital Structure Components and Their Weights

Pickerington Communications' capital structure comprises debt, preferred stock, and common equity with respective proportions of 30%, 10%, and 60%. These proportions reflect the company's optimal capital mix, designed to balance risk and return. In weighting these components for the WACC calculation, each component’s percentage in the total capital is used directly: 0.30 for debt, 0.10 for preferred stock, and 0.60 for common equity. These weights are crucial in blending the associated costs to obtain an overall cost of capital reflective of the company's financing strategy.

Calculation of After-Tax Cost of Debt

The before-tax cost of debt is provided as 9%. The after-tax cost of debt (ATCOD) adjusts for tax savings due to interest deductibility, calculated as:

ATCOD = Pre-tax cost of debt × (1 - Tax rate)

At a 25% tax rate, the after-tax cost of debt is:

ATCOD = 9% × (1 - 0.25) = 9% × 0.75 = 6.75%

If the tax rate remains at 25%, the after-tax cost remains at 6.75%. The adjustment ensures the company recognizes tax savings, reducing the effective cost of debt financing.

Cost of Preferred Stock

The cost of preferred stock (Kp) is calculated using the dividend and net issuing price, accounting for flotation costs:

Kp = (Dividend / (Net proceeds per share))

Dividends per preferred share = $9, flotation costs per share = $5, thus net proceeds = $100 - $5 = $95.

Kp = $9 / $95 ≈ 9.47%

This rate represents the return required by preferred shareholders, considering the floatation costs involved in issuing new preferred stock.

Cost of Common Stock

Using CAPM

The Capital Asset Pricing Model (CAPM) estimates the cost of equity (Ke) as:

Ke = Risk-free rate + Beta × Market risk premium

= 6% + 1.3 × 5% = 6% + 6.5% = 12.5%

Using Dividend Growth Model

The dividend growth model (DGM) calculates Ke as:

Ke = (D1 / P0) + g

First, compute D1, the expected dividend for next year:

D1 = D0 × (1 + g) = $3.70 × 1.06 = $3.922

Ke = $3.922 / $60 + 6% ≈ 0.06537 + 0.06 = 12.54%

Both methods yield similar estimates, with the dividend growth approach providing a dividend-based perspective and the CAPM incorporating market risk factors.

Calculating the Weighted Average Cost of Capital (WACC)

WACC is calculated by weighting each component's cost by its proportion in the capital structure:

WACC = (Wd × After-tax cost of debt) + (Wp × Cost of preferred stock) + (We × Cost of equity)

Where:

  • Wd = 0.30
  • Wp = 0.10
  • We = 0.60

Substituting values:

WACC = (0.30 × 6.75%) + (0.10 × 9.47%) + (0.60 × 12.54%)

WACC = 2.025% + 0.947% + 7.524% ≈ 10.5%

This indicates the average rate of return the company needs to generate to satisfy its capital providers.

After-Tax Cost of Debt Under Different Tax Scenarios

Assuming future long-term bonds with a YTM of 13% and a coupon rate of 10%, the before-tax cost of debt is 13%. The after-tax cost of debt varies with tax rate changes:

  • Tax rate at 25%: ATCOD = 13% × (1 - 0.25) = 9.75%
  • Tax rate at 20%: ATCOD = 13% × (1 - 0.20) = 10.4%
  • Tax rate at 35%: ATCOD = 13% × (1 - 0.35) = 8.45%

These calculations show how changes in taxation impact the company's effective cost of debt, influencing financing decisions.

Factors Management Cannot Control

  • Market interest rates: Fluctuations affect borrowing costs but are outside managerial influence.
  • Economic conditions: Broader economic trends impact investor risk appetite and cost of capital.
  • Tax policies: Changes in tax legislation are determined by government policy, outside management control.

Factors Management Can Control

  • Capital structure composition: Adjusting the debt-equity mix influences overall cost of capital.
  • Dividend policy: Setting dividend payout ratios can affect retained earnings and reinvestment capacity.
  • Operational efficiency: Improving productivity can reduce risk and thus decrease the cost of capital.

Conclusion

Effective management of the capital structure and understanding of various costs is essential for optimizing a company's value. By accurately calculating the costs associated with debt, preferred stock, and equity, and understanding how external factors influence these costs, PCI can develop strategies to minimize its WACC, thereby enhancing shareholder value. Recognizing controllable versus uncontrollable factors enables targeted decision-making to maintain financial stability amid changing market conditions.

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