Integrative Case 1 Eco Plastics Company
Since itsinception, Eco Plastics Company has been revolutionizing plastic and trying todo its part to save the environment. Eco’s founder, Marion Cosby, developed a biodegradableplastic that her company is marketing to manufacturing companies throughout thesoutheastern United States. After operating as a private company for six years,Eco went public in 2009 and is listed on the Nasdaq stock exchange.
As the chief financialofficer of a young company with lots of investment opportunities, Eco’s CFOclosely monitors the firm’s cost of capital. The CFO keeps tabs on each of theindividual costs of Eco’s three main financing sources: long-term debt,preferred stock, and common stock. The target capital structure for ECO isgiven by the weights in the following table:
Source of capital
Long-term debt 30% Preferred stock 20 Common stock equity 50 Total 100%
At the presenttime, Eco can raise debt by selling 20-year bonds with a $1,000 par value and a
10.5% annual coupon interest rate. Eco’s corporate tax rate is 40%, and itsbonds generally require an average discount of $45 per bond and flotation costsof $32 per bond when being sold. Eco’s outstanding preferred stock pays a 9%dividend and has a $95-per-share par value. The cost of issuing and sellingadditional preferred stock is expected to be $7 per share. Because Eco is ayoung firm that requires lots of cash to grow it does not currently pay adividend to common stock holders. To track the cost of common stock the CFOuses the capital asset pricing model (CAPM). The CFO and the firm’s investmentadvisors believe that the appropriate risk-free rate is 4% and that themarket’s expected return equals 13%. Using data from 2009 through 2012, Eco’sCFO estimates the firm’s beta to be 1.3.
Although Eco’scurrent target capital structure includes 20% preferred stock, the company is
considering using debt financing to retire the outstanding preferred stock,thus shifting their target capital structure to 50% long-term debt and 50%common stock. If Eco shifts its capital mix from preferred stock to debt, itsfinancial advisors expect its beta to increase to 1.5.
a. Calculate Eco’s currentafter-tax cost of long-term debt.
b. Calculate Eco’s current costof preferred stock.
c. Calculate Eco’s current costof common stock.
d. Calculate Eco’s currentweighted average cost capital.
e. (1) Assuming that the debtfinancing costs do not change, what effect would ashift to a more highly leveragedcapital 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?
(2) What would be Eco’s newweighted average cost of capital?
(3) Which capital structure—theoriginal one or this one—seems better? Why?