# Apply: Berkshire Instruments Case Study

PurposeThis assignment allows students to work with issues related to the cost of capital. In addition, students will practice calculations related to capital structure and use them in making financial decisions.Assignment InstructionsReview the Week 3 Case Study.Complete the required activities 1 to 3 in Microsoft® Excel® or Microsoft® Word.Click the Assignment Files tab to submit your assignment.
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Week 3 Case Study
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FIN/486 Version 6 1
Berkshire Instruments
Al Hansen, the newly appointed vice president of finance of Berkshire Instruments, was eager to talk to
his investment banker about future financing for the firm. One of Als first assignments was to
determine the firms cost of capital. In assessing the weights to use in computing the cost of capital, he
examined the current balance sheet, presented in Figure 1 below.
In their discussion, Al and his investment banker determined that the current mix in the capital structure
was very close to optimal and that Berkshire Instruments should continue with it in the future. Of some
concern was the appropriate cost to assign to each of the elements in the capital structure. Al Hansen
requested that his administrative assistant provide data on what the cost to issue debt and preferred
stock had been in the past. The information is provided in Figure 2 below.
When Al got the data, he felt he was making real progress toward determining the cost of capital for the
firm. However, his investment banker indicated that he was going about the process in an incorrect
manner. The important issue is the current cost of funds, not the historical cost. The banker suggested
that a comparable firm in the industry, in terms of size and bond rating (Baa), Rollins Instruments, had
issued bonds a year and a half ago for 9.3 percent interest at a \$1,000 par value, and the bonds were
currently selling for \$890. The bonds had 20 years remaining to maturity. The banker also observed that
Rollings Instruments had just issued preferred stock at \$60 per share, and the preferred stock paid an
annual dividend of \$4.80.
In terms of cost of common equity, the banker suggested that Al Hansen use the dividend valuation
model as a first approach to determining cost of equity. Based on that approach, Al observed that
earnings were \$3 a share and that 40 percent would be paid out in dividends (D1). The current stock
price was \$25. Dividends in the last four years had grown from 82 cents to the current value.
The banker indicated that the under-writing cost (flotation cost) on a preferred stock issue would be
\$2.60 per share and \$2.00 per share on common stock. Al Hansen further observed that his firm was in a
35 percent marginal tax bracket.
With all this information in hand, Al Hansen sat down to determine his firms cost of capital. He was a
little confused about computing the firms cost of common equity. He knew there were two different
formulas: One: One for the cost of retained earnings and one for the cost of new common stock. His
investment banker suggested that he follow the normally accepted approach used in determining the
marginal cost of capital. First, determine the cost of capital for as large a capital structure as current
retained earnings will support; then, determine the cost of capital based on exclusively using new
common stock.
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Week 3 Case Study
reserved.
FIN/486 Version 6 2
Figure 1
BERKSHIRE INSTRUMENTS
Statement of Financial Position
December 31, 2015
Assets
Current assets:
Cash ………………………………………………………………………….
Marketable securities …………………………………………………..
Accounts receivable …………………………………………………….
Inventory ……………………………………………………………………
Total current assets ………………………………………………….
Fixed Assets:
Plant and equipment, original cost …………………………………
Less: Accumulated depreciation ………………………………..
Net plant and equipment ………………………………………………
Total assets ……………………………………………………………………
\$
\$ 2,600,000
300,000
400,000
200,000
2,300,000
5,500,000
\$ 8,400,000
30,700,000
13,200,000
17,500,000
\$25,900,000
Liabilities and Stockholders Equity
Current liabilities: …………………………………………………………..
Accounts payable ………………………………………………………..
Accrued expenses ……………………………………………………….
Total current liabilities ……………………………………………..
\$ 6,200,000
1,700,000
7,900,000
Long-term financing:
Bonds payable …………………………………………………………….
Preferred stock ……………………………………………………………
Common stock
\$ 6,120,000
1,080,000
6,300,000
Retained earnings
} Common equity
4,500,000
Total common equity ……………………………………………….
Total long-term financing ……………………………………..
Total liabilities and stockholders equity ……………………………
10,800,000
18,000,000
\$25,900,000
Figure 2
Cost of prior issues
Security
Year of Issue
Amount
Coupon Rate
Bond ………………………………………
2003
\$1,120,000
Bond ………………………………………
2007
3,000,000
13.8
Bond ………………………………………
2013
2,000,000
8.3
of debt and
preferred stock
6.1%
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Week 3 Case Study
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FIN/486 Version 6 3
Preferred stock …………………………
2008
600,000
12.0
Preferred stock …………………………
2011
480,000
7.9
Required Activities:
1. Determine the weighted average cost of capital based on using retained earnings in the capital
structure. Note: The percentage composition in the capital structure for bonds, preferred stock,
and common equity should be based on the current capital structure of long-term financing as
shown in Figure 1 above (it adds up to \$18 million). Common equity will represent 60 percent of
financing throughout this case. Use Rollins Instruments data to calculate the cost of preferred stock
2. Recompute the weighted average cost of capital based on using new common stock in the capital
structure. Note: The weights remain the same, only common equity is now supplied by new
common stock, rather than by retained earnings. After how much new financing will this increase
in the cost of capital take place? Determine this by dividing retained earnings by the percent of
common equity in the capital structure. Show your work on your assignment document.
3. Write a 1 page summary that provides the following :
A. Differentiate between the methods used in question 1 above and those used in question
2 above as it relates to the results.
B. Provide your opinion on which method you would suggest and why, based on your
findings.
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