Richard Keith was employed in the medical supply field for many years before he founded Southern Medical Supply (SMS) in Atlanta, Georgia in 1981.

Richard Keith was employed in the medical supply field for many years before he founded Southern Medical Supply (SMS) in Atlanta, Georgia in 1981. Keith never
thought firms in the medical supply field were run very well and he thought he could do better. When he started SMS, the firm sold medical supplies only to
hospitals in the Atlanta area. Over time his business grew slowly until it serviced many hospitals in five southeastern states. Recently, SMS added a new
product development division to the firm. This new division creates and produces new products for sale and distribution. These new products are generally
similar to existing products but with marginal improvements. Thus far, SMS has begun producing its own wheelchairs and hospital beds. The product development
division is more risky than the medical supply division because sometimes large amounts of money are spent developing new products that do not prove to be
commercially viable.

Keith’s experience is mostly in marketing and now that SMS has grown to employ 125 people, Keith is concerned that he can no longer manage the firm’s finances
effectively. Five years ago, SMS issued both bonds and preferred stock to raise money for expansion. Last year, the firm went public with an IPO raising $30
million. But Keith never felt comfortable relying on investment bankers to make all the decisions for his firm regarding financial matters. He felt that some
of these decisions should be made internally. The firm’s narrowing profit margins also concern Keith. As a result of Keith’s concerns, he hired a new CFO,
Karen Thomas, who had been the controller of an Atlanta hospital.

SMS currently has the opportunity to buy a firm that sells medical supplies to hospitals in Louisiana, Texas, New Mexico, and Arizona. SMS currently operates
in only one of those states, Louisiana. Keith has asked Thomas to formalize the calculation of the firm’s cost of capital. In the past, the firm had used 12.0
percent to represent the cost of capital for all projects. No one knows where that number came from, but some people in the firm suspect the number was used
because that is commonly used to represent the average nominal return on the stock market during the past 30 years.

Table 1 presents SMS’s balance sheet on December 31, 2010.

Table 1

Southern Medical Supply, Inc.

Balance Sheet for the Year Ended December 31, 2010

(in Millions of Dollars)

Cash and equivalents 4.2 Accounts payable 2.9

Accounts receivable 17.8 Accruals 3.8

Inventory 5.6 Notes payable .8

Total current assets 27.6 Total current liabilities 7.5

Net fixed assets 56.7 Long-term debt 30.4

Total assets 84.3 Preferred stock 8.3

Common equity 38.1

Total liabilities and equity 84.3

Thomas began her analysis of the firm’s WACC by collecting the following information:

(1) The firm’s federal-plus-state tax rate is 40 percent.

(2) SMS uses no short-term debt to finance capital assets.

(3) The firm currently has some long-term debt outstanding. This debt consists of 10.5 percent coupon bonds paying interest semiannually. The bonds were issued
5 years ago with an original maturity of 20 years. The bonds are not callable and they are rated BBB. The bonds currently sell for $920 for each $1,000 par
value bond and the yield curve is flat. The firm has decided to raise additional debt funds in the future by issuing 20-year bonds.

(4) The required rate of return on an average 20-year A-rated bond is currently 10.9 percent.

(5) The average yield on long-term U.S. Treasury bonds is currently 8.2 percent and the average yield on Treasury Bills is 6.4 percent.

(6) SMS paid a common stock dividend of $1.24 during the past 12 months. For the foreseeable future, the firm expects its dividend to grow at the same rate as
it has in the past. SMS’s stock currently sells for $14.00 per share and the firm has 4 million shares outstanding.

(7) The firm’s outstanding preferred stock is noncallable and perpetual and pays a quarterly dividend of $2.40 a share. While the par value of the preferred
stock is $100, the stock currently sells for $89.00. The par value of any new preferred stock also will be $100 and the flotation cost for firm’s preferred
stock is 3%.

(8) The firm’s beta is estimated to be 1.4 and the market risk premium is estimated to be 4.5 percent.

(9) The target capital structure for SMS includes 35 percent long-term debt, 15 percent preferred stock, and 50 percent common equity.

(10) The firm’s investment bankers estimate that the firm will incur flotation costs when issuing new common stock equal to approximately 20 percent of the
market value of the stock.

(11) The firm’s investment bankers also estimate that investors require a return on the firm’s common stock that is 3.2 percentage points higher than the
return they require on the firm’s bonds.

(12) SMS estimates that it will be able to retain $1.2 million of earnings in the coming year. The firm also expects depreciation expense next year to total
$2.3 million.

(13) The firm’s per share dividend history over the past 5 years is as follows:

Year Dividend

2006 $1.02

2007 1.05

2008 0.92

2009 1.18

2010 1.24

Thomas recently hired you as a financial analyst for the SMS. Your first assignment is to help Thomas estimate SMS’s WACC. Specifically, you are to
calculate (estimate):

A. The firm’s after-tax cost of debt.

B. The firm’s cost of preferred stock.

C. The firm’s cost of retained earnings (calculate it using three methods and use the average of the three as your final answer).

D. The firm’s cost of new common stock.

E. The firm’s WACC using retained earnings as the source of equity.

F. The firm’s WACC using new common stock as the source of equity.