Question

The capital structure for ECO is 40% debt, 10% preferred stock, 50% common stock equity. Tax 30% Eco current debt is a loan at 8% stated interest rate. Eco’s preferred stock pays a 9% dividend and has a $100-per-share par value. Eco does not currently pay a dividend to common stockholders. In order to track the cost of common stock the CFO uses the capital asset pricing model (CAPM). The CFO and the firm’s investment advisors believe that the appropriate risk-free rate is 4% and that the market’s expected return equals 13%. Beta is 1.3. Although Eco’s current target capital structure includes 10% preferred stock, the company is considering using debt financing via a new bond issue to retire the outstanding preferred stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.5. New debt would be in the form of bonds requiring an average discount of $30 per bond and flotation costs of $20 per bond from Par value and would be issued for 15 years at a 7.5% coupon rate.

a. IF they change their capital structure, what would be Eco’s new cost of debt?
b. What would be the new cost of common equity?
c. What would be Eco’s new weighted average cost of capital?
d. Which capital structure—the original one or this one—seems better? Why?

Answer 1

Eco's change in capital structure involves recalculating the cost of debt and equity, determining the new WACC, and comparing risks and benefits to decide which structure is better.

Step-by-step explanation:

If Eco decides to change its capital structure by issuing new bonds to retire preferred stock, several cost calculations must be performed. Firstly, the new cost of debt accounts for the newly issued bonds, which carry a 7.5% coupon rate, and additional discount and flotation costs that would impact the yield to maturity. The total discount and flotation costs per bond reduce the net proceeds, which should be considered when calculating the after-tax cost of debt.

Next, the new cost of common equity needs to be estimated using the revised beta factor in the CAPM formula. Since financial leverage impacts the riskiness of common stock, a higher beta reflects this increased risk. The new beta, the risk-free rate, and the expected market return are used to determine the cost of equity after modifying the capital structure.

Once we have the new costs of debt and equity, we can calculate Eco's new weighted average cost of capital (WACC) by considering the target weight of each component - which now excludes preferred stock and includes more debt - and their respective costs. The WACC is crucial in determining the attractiveness of the new capital structure compared to the original one.

Finally, deciding on whether the original or the new capital structure is better would depend on the comparison of WACC, the company's level of risk, financial flexibility, and other strategic considerations. A lower WACC might suggest increased value, but the added risk inherent with a higher proportion of debt should also be accounted for, as it affects Eco's financial risk profile and potential cost of financial distress.