Calculation & Recommendation I Would Thesis

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Using a bond calculator, we know that their current bonds are yielding 6.76%. Once adjusted for annual interest to accommodate the bond calculator, the Magna bonds are trading at a yield of 8.60%. This means the yield needed for our new bonds is 8.90% over 25 years. Given the issue price of 102.00, this will require a coupon of 10.3%. Add to this the 2.2% cost. This brokerage fee is tax-deductible, so the after tax cost of the brokerage fee is 1.76%. Thus, the total cost of debt for Byfield is 10.3+1.76 = 12.06%.

The current yield on Byfield preferred stock is 8.95%. Add to this the cost of issuing the stock, which is 2.7%, or 2.16% after tax, and the cost of preferred equity is 11.11%. We can use the dividend discount model to calculate the cost of equity, which will be 19.1%. Add to this the after-tax brokerage costs 3.864% to get a cost of equity of 22.964%. From there, the weighted average cost of capital is going to be (.38)(.1206)+(.14)(11.11)+(.48)(.2296) = 17.15%.

Based on this average cost of capital, the only project that Byfield should undertake will be the thermal transfer colour printer. This project has an expected return of 18.8%, which is greater than the cost of capital (hurdle rate).

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The other two projects will return less than they cost.

b. In the phrase "cost of capital," the debt, preferred stock and equity all have a cost. To raise money via each of these requires making payment to the party providing the money. In the case of equity, this is future cash flows and those are not guaranteed, which is why the cost of equity is highest (it is riskier). But Byfield must provide a return to the provider of the capital that is commensurate with the company's risk.

Knowing the cost of capital is critical for a company. Because raising capital has costs - returns given and brokerage fees - associated with it, any investment the firm makes must exceed the cost of capital. Any project undertaken that does not yield in excess of the cost of capital is, in effect, costing the company money. The thermal printer is a viable project because it will earn Byfield more than it costs (assuming Byfield leaves its capital structure intact). The other projects will also earn Byfield money, but they will not earn Byfield enough money to pay for the cost of the money Byfield spent to undertake the project. Thus, the cost of capital becomes the basis for all capital decisions,.....

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