The Cost of Capital: How Much Does it Cost to Raise Money?

A. Bad Boys, Inc. is evaluating its cost of capital. Under consultation, Bad Boys, Inc. expects to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Bad Boys, Inc. is currently selling for $20.00 a share. Bad Boys, Inc. expects to pay a dividend of $1.50 per share next year. An equity analyst foresees a growth in dividends at a rate of 5% per year. Bad Boys, Inc. marginal tax rate is 35%. If Bad Boys, Inc. raises capital using 45% debt, 5% preferred stock, and 50% common stock, wh at is Bad Boys cost of capital?

Using the dividend growth model, the cost of capital is computed as follows:

Cost of Capital = 0.5 * 12.50% + 0.05 * 10% + 0.45 * 5.2%

= 9.09%

B. If Bad Boys, Inc. raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Bad Boys cost of capital? 

The assumption used to calculate the cost of capital is that the resulting cost of each factor is constant. Therefore, cost of capital of Bad Boys can be calculated as follows:

The associated Cost of capital = weights * cost of capital of the sources of capital

= (30% X 5.2%) + (5% X 10%) + (65% *X 12.50%)

Weighted Average cost of capital = 10.9 % 

C. On page 457, your textbook details the term Cannibalization. In your own words, identify two corporations that have dealt with cannibalization and what steps were taken to overcome the cannibalization. Please provide any citations and references. Please be articulate in your responses. 

A business can opt to introduce a new product to add to its portfolio as one of its diversification strategies. From the market research conducted on the introduction of the new product, an organization usually anticipates that the product will result in an increase in its overall revenue without affection the sales of other existing products. However, cannibalization refers to a situation the introduction of a new product reduces the sales or the demand of another existing product thus leading to an overall decrease in revenue. The market share of the old product is taken up by the new product.

Gillette company is one of the most renown organization that faces cannibalization. The firm introduces new razor blades periodically into the market. However, it is estimated that whenever a new product is introduced, such as the Gillette sensor blade, two thirds of the new sales result from the consumers are the existing business customers who would have otherwise been using their older razors. Each of the new blade that is introduced by the firm causes a high cut-throat competition to the company’s predecessor blades. To overcome cannibalization, the company uses a different pricing strategy that allows the original products to sell due to its affordability as compared to the new products being introduced ( Bordley & Karnani, 2017). 

Apple company also faced cannibalization after introducing the iPad. The introduction of this new and more innovative product resulted to a decrease in sales of its then existing product, the Mac computers. The existing market share of the company opted for the newer and more innovating product yet the company’s target when introducing the iPad as to tap a higher market segment. For the company to curb cannibalization, they opted to producing more innovative products whose features are different from the existing products ( Bordley & Karnani, 2017) . They also targeted a different market from that which they controlled. This resulted to each new product surviving with a new market and the older products retaining its customers.

References

Bordley, R. F., & Karnani, A. (2017). Using incentives to address cannibalization.    Long Range Planning . 

Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital.    Journal of Financial Economics ,    119 (2), 300-315. 

Mukherjee, S. (2017). Cost of capital.    Asian Journal of Multidimensional Research (AJMR) ,    6 (7), 115-118.