FIN/402 BSAJ0ZRTO0- Since its inception, Eco Plastics Company has been revolutionizing plastic

| June 14, 2018

Since its inception, Eco Plastics Company has been revolutionizing plastic and trying to do its part to savethe environment. Eco’s founder, Marion Cosby, developed a biodegradable plastic that her company ismarketing to manufacturing companies throughout the southeastern United States. After operating as aprivate company for 6 years, Eco went public in 2012 and is listed on the Nasdaq stock exchange.As the chief financial officer of a young company with lots of investment opportunities, Eco’s CFO closelymonitors the firm’s cost of capital. The CFO keeps tabs on each of the individual costs of Eco’s three mainfinancing sources: long-term debt, preferred stock, and common stock. The target capital structure forEco is given by the weights in the following table:Source of capitalWeightLong-term debt30%Preferred stock20Common stock equity50Total100%At 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 averagediscount of $45 per bond and flotation costs of $32 per bond when being sold. Eco’s outstandingpreferred 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 a young firm that requires lotsof cash to grow it does not currently pay a dividend to common stockholders. To track the cost ofcommon stock the CFO uses the capital asset pricing model (CAPM). The CFO and the firm’s investmentadvisors believe that the appropriate risk-free rate is 4% and that the market’s expected return equals13%. Using data from 2012 through 2015, 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 consideringusing debt financing to retire the outstanding preferred stock, thus shifting their target capital structureto 50% long-term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt,its financial advisors expect its beta to increase to 1.5.TO DOa. 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 highlyleveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% commonstock have on the risk premium for Eco’s common stock? What would be Eco’s new cost of commonequity?(2) What would be Eco’s new weighted average cost of capital?(3) Which capital structure—the original one or this one—seems better? Why?

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