Chp. 9 Minicase

Chp. 9 Mini Case

During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Harry Davis's cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task.

1. The firm's tax rate is 40%

2. The current price of Harry Davis's 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use short term % bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

3. The current price of the firm's 10%, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Harry Davis would incur flotation costs of $2.00 per share on a new issue.

4. Harry Davis's common stock is currently selling at $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Harry Davis's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond yield plus risk premium approach, the firm uses a 4% point risk premium.

5. Harry Davis's target capital structure is 30% long term debt, 10% preferred stock, and 60% common equity.

To structure the task somewhat, Jones has asked you to answer the following questions.

a. 1. What sources of capital should be included when you estimate Harry Davis's weighted average cost of capital (WACC)?

Long term: long term debt, preferred stock, common stock

Short term: non-interest bearing liabilities, interest bearing debt

2. Should the component costs be figured on a before tax or an after tax basis?

After tax basis

3. Should the costs be historical (embedded) costs or new (marginal) costs?

Marginal costs

b. What is the market % rate on Harry Davis's debt and its component cost of debt?

12%, 15 yr., $1,153.72 = 5% times (2) = 10%

component cost kd (1- T) = 10%(1-.40) = 10% (.60) = 6%

c. 1. What is the firm's cost of preferred stock?

Kps = Dpn = 0.1 ($100) = $10 = 0.090 = 9%

$133.10 - $2 $111.10

2. Harry Davis's preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Taxes)

Preferred dividends are nontaxable and this causes it to have a lower before tax yield than debt.

d. 1. What are the two primary ways companies raise common equity?

1. Retaining earnings

2. Issuing new common stock

2. Why is there a cost associated with reinvested earnings?

Opportunity cost, reinvesting the earnings means they won't actually be able to use the money for what they want.

3. Harry Davis doesn't plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis's estimated cost of equity?

.07 + (.06) 1.2 = 14.2%

e. 1. What is the estimated cost of equity using the discounted cash flow (DCF) approach?

4.19 (1.05) + .50 = 13.8%

$50

2. Suppose the firm has historically earned 15% on equity (ROE) and retained 35% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this constant with the 5% growth rate given earlier?

g = (.35) 0.15 = 5.25%, is consistent

3. Could the DCF method be applied if the growth rate was not constant? How?

DCF could be used even if the growth rate was nonconstant. Add the PV of nonconstant to PV of constsnt.

f. What is the cost of equity based on the bond yield plus risk premium method?

Comp. bond yield + Risk premium

k = 10% (5 times 2)

risk premium is 4%

10 + 4 = 14%

g. What is your final estimate for the cost of equity, rs?

CAPM 14.2

DCF 13.8

B. Y. + R. P. 14.0

Avg. 14

h. What is Harry Davis's weighted average cost of capital (WACC)?

WACC = 0.3 (.10) (.6) + .1 (.09) + .6 (.14)