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PA 02 - Integrative Case - Eco Plastics Company

This document contains Eco Plastics Company's calculations for its current cost of capital. It first calculates the after-tax cost of long-term debt as 6.79%, the cost of preferred stock as 9.72%, and the cost of common stock as 15.7%. It then calculates the weighted average cost of capital as 11.54% based on the current capital structure. It then analyzes how shifting to a more leveraged capital structure of 50% debt and 50% equity would impact the cost of common equity and weighted average cost of capital. The new cost of common equity is calculated as 17.5% and the new weighted average cost of capital is 12.15%. It determines the original capital structure is better

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2K views3 pages

PA 02 - Integrative Case - Eco Plastics Company

This document contains Eco Plastics Company's calculations for its current cost of capital. It first calculates the after-tax cost of long-term debt as 6.79%, the cost of preferred stock as 9.72%, and the cost of common stock as 15.7%. It then calculates the weighted average cost of capital as 11.54% based on the current capital structure. It then analyzes how shifting to a more leveraged capital structure of 50% debt and 50% equity would impact the cost of common equity and weighted average cost of capital. The new cost of common equity is calculated as 17.5% and the new weighted average cost of capital is 12.15%. It determines the original capital structure is better

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Submitted by: Submitted to:

Alvarez, Paul John Dr. Christhoffer P. Lelis, LPT


Bagang, Alessandra Francheska ACFAR 3335 Professor
Lavarias, Febbie Novem
BSA 3B Date: April 27, 2023

Preparatory Assessment 2 - Integrative Case: Eco Plastics Company

a. Calculate Eco’s current after-tax cost of long-term debt.


Formula of Before Tax Cost of Debt:

Formula of After-Tax Cost of Debt:

Given:
Par Value = $1,000
Coupon Rate = 10.50%
Net Proceeds = $923
Years of Maturity = 20
Tax Rate = 40%

Solution:
b. Calculate Eco’s current cost of preferred stock.
Formula of Cost of Preferred Stock:

Cost of Preferred Stock = Annual Dividend / Net Proceeds

Formula of Net Proceeds:

Net Proceeds = Share Price - Flotation Costs

Given:
Preferred Stock Annual Percentage Rate = 9%
Share Price = $95
Flotation Costs = $7

Solution:

Annual Dividend = 9% x $95


Annual Dividend = $8.55

Net Proceeds = $95 - $7


Net Proceeds = $88

Cost of Preferred Stock = $8.55 / $88


Cost of Preferred Stock = 9.72%

c. Calculate Eco’s current cost of common stock.


Formula of Cost of Common Stock:

Cost of Common Stock = Risk-free rate + Beta (Market Rate - Risk-free Rate)

Solution:
Cost of Common Stock = 4% + 1.3 (13% - 4%)
Cost of Common Stock = 15.7%

d. Calculate Eco’s current weighted average cost capital.

Source of Capital Cost of capital Weight Weighted Average


Cost Capital

Long-term debt 6.79 40% 2.72%

Preferred Stock 9.72 10% 0.97%


Common Stock 15.70 50% 7.85%

Weighted Average 11.54%


Cost of Capital

e. (1) Assuming that the debt financing costs do not change, what effect would a
shift to a more highly leveraged capital structure consisting of 50% long-term
debt, 0% preferred stock, and 50% common stock have on the risk premium for
Eco’s common stock? What would be Eco’s new cost of common equity?
Change of beta
Formula of Cost of Common Stock:

Cost of Common Stock = Risk-free rate + Beta (Market Rate - Risk-free Rate)

Solution:
Cost of Common Stock = 4% + 1.5 (13% - 4%)
Cost of Common Stock = 17.5%

(2) What would be Eco’s new weighted average cost of capital?

Source of Capital Cost of Capital Weight Weighted Average


Cost Capital

Long-term debt 6.79 50% 3.40%

Common Stock 17.5 50% 8.75%

Revised Weighted 12.15%


Average Cost of
Capital

(3) Which capital structure–the original one or this one–seems better? Why?

The lower the Weighted Average Cost of Capital, the more the business
investments are reliable and consistent, making it more desirable. Otherwise, it would
increase risk for stockholders, and the higher required rate of return would outweigh the
benefits of the lower cost of debt. Thus, the original capital structure, with 11.54%, is
found to be better compared to the revised one.

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