Cost of Capital. Timel Company is in the process of determining its capital budget for the coming fiscal year. Timel Company’s balance sheet reflects five sources of long-term funds. The current outstanding amounts from these five sources are shown bellow and represent the company’s historical sources of funds fairly accurately.
Source of Funds $ Amount (in Millions) Percentage
Mortgage bonds ($1,000 par, 7
%) 135 15.0
Debentures ($1,000 par, 8%, due 20X5) 225 25.0
Preferred stock ($100 par, 7
%) 90 10.0
Common stock ($10 par) 150 16.7
Retained earnings 300 33.3
900 100.0
Timel will raise the funds necessary to support the selected capital investment projects so as to maintain its historical distribution among the various sources of long-term funds. Thus, 15 percent will be obtained from additional mortgage bonds on new plant, 25 percent from debentures, 10 percent from preferred stock, and 50 percent from some common equity source. Timel’s policy is to reinvest the funds derived from each year’s earnings in new projects. Timel issues new common stock only after all funds provided from retained earnings have been exhausted.
Management estimates that its net income after taxes for the coming year will be $4.50 per common share. The dividend payout ratio will be 40 percent of earnings to common shareholders ($1.8 per share), the same ratio as the prior 4 years. The preferred stockholders will receive $6.75 million. The earnings retained will be used as needed to support the capital investment program.
The capital budgeting staff, in conjunction with Timel’s investment broker, has developed the following data regarding Timel’s sources of funds if it were to raise funds in the current market.
Source of Funds Par Value ($) Interest or Dividend Rate (%) Issue Price ($)
Mortgage bonds 1,000 14 1,000.00
Debentures 1,000 14
1,000.00
Preferred stock 100 13 99.25
Common stock 10 67.P
The estimated interest rates on the debt instruments and the dividend rate on the preferred stock are based upon the rates being experienced in the market by firms which are of the same size and quality as Timel. The investment banker believes that the price of $67.50 for the common stock is justified, since Timels’s price/earnings ratio of 15 is consistent with the 10 percent earnings growth rate that the market is capitalizing
Timel is subject to a 40 percent income tax rate.
Calculate (a) the after-tax marginal cost of capital for each of the five sources of capital for Timel Company, and (b) Timel Company’s after-tax weighted average cost of capital. (c) Timel Company follows a practice that 50 percent of any funds raised will be derived from common equity sources. Determine the point of expansion at which Timel’s source of common equity funds would switch from retained earnings to new common stock in the coming year. (d ) If the basic business risks are similar for all firms in the industry in which Timel Company participates, would all firms in the industry have approximately the same weighted average cost of capital? Explain your answer. (CMA, adapted.)