Eco Plastics Company
Since its inception, Eco Plastics Company has been revolutionizing
plastic and trying to do its part to save the environment. Eoc s
founder, Marion Cosby, developed a biodegradable plastic that her
company is marketing to manufacturing companies throughout the
southeastern United States. After operating as a private company for six
years, Eco went public in 2009 and is listed on the Nasdaq stock
As the chief financial officer of a young company with lots of
investment opportunities. Eco s CFO closely monitors the firm s cost of
capital. The CEO keeps tabs on each of the individual cost of Eco s
three main financing sources: long-term debt, preferred stock, and
common stock. The target capital structure for ECO is given by the
weights in the following table:
Source of capital
Common stock equity
As the present time, 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 its bonds generally require an average
discount of $45 per bond and floatation cost of $32 per bound when being
sold. Eco s outstanding preferred stock pays a 9% dividend and has a
$95-per-shar par value. The cost of issuing and selling addional
preferred stock is expected to be $7 per share. Because Eco is a young
firm that requires lots of cash to grow it does not currently pay a
dividend to common stock holders. 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%. Using data from 2009
through 2012, Eco s CFO estimates the firm s beta to be 1.3.
Although Eco s current 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, its financial
advisors expects its beta to increase to 1.5.
a. Calculate Eco s current after-tax cost of long-term debt.
b. Calculate Eco s current cost of preferred stock.
c. Calculate Eco s current cost of common stock.
d. Calculate Eco s current weighted average cost 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?