During the past few years, Harry Davis Industries has been too constrained by the high cost of
Question:
1. The firm's tax rate is 35%.
2. The current price of Harry Davis' 8% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,091.96. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
3. The current price of the firm's 6%, $25 par value, quarterly dividend, perpetual preferred stock is $19.74. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue.
4. Harry Davis' common stock is currently selling at $50 per share. Its last dividend (D0) was $2.00, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Harry Davis' beta is 1.2, the yield on government bonds is 4%, and the market risk premium is estimated to be 5%. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.
5. Harry Davis' 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' weighted average cost of capital (WACC)?
2. Should the component costs be figured on a before-tax or an after-tax basis?
3. Should the costs be historical (embedded) costs or new (marginal) costs?
(b) What is the market interest rate on Harry Davis' debt and its component cost of debt?
Optional Question 1: Should flotation costs be included in the estimate?
Optional Question 2: Should you use the nominal cost of debt or the effective annual cost?
(c) What is the firm's cost of preferred stock?
(d)
1. What are the two primary ways companies raise common equity?
2. Why is there a cost associated with reinvested earnings?
3. Harry Davis doesn't plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis' estimated cost of equity?
(e)
1. What is the estimated cost of equity using the discounted cash flow (DCF) approach?
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 consistent with the 5% growth rate given earlier?
3. Could the DCF method be applied if the growth rate was not constant? How?
(f) What is the cost of equity based on the bond-yield-plus-risk-premium method?
(g) What is your final estimate for the cost of equity, rs?
(h) What is Harry Davis' weighted average cost of capital (WACC)?
(i) What factors influence a company's WACC?
(j) Should the company use the composite WACC as the hurdle rate for each of its divisions?
(k) What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approach is used to measure a division's beta?
(l) What are three types of project risk? How is each type of risk used?
(m) Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings.
(n)
1. Harry Davis estimates that if it issues new common stock, the flotation cost will be 15%. Harry Davis incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, taking into account the flotation cost?
2. Suppose Harry Davis issues 30-year debt with a par value of $1,000 and a coupon rate of 7%, paid annually. If flotation costs are 2%, what is the after-tax cost of debt for the new bond?
(o) What four common mistakes in estimating the WACC should Harry Davis avoid? Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on... Discounted Cash Flows
What is Discounted Cash Flows? Discounted Cash Flows is a valuation technique used by investors and financial experts for the purpose of interpreting the performance of an underlying assets or investment. It uses a discount rate that is most... Capital Structure
Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a... Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of... Cost Of Debt
The cost of debt is the effective interest rate a company pays on its debts. It’s the cost of debt, such as bonds and loans, among others. The cost of debt often refers to before-tax cost of debt, which is the company's cost of debt before taking... Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the... Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a... Dividend
A dividend is a distribution of a portion of company’s earnings, decided and managed by the company’s board of directors, and paid to the shareholders. Dividends are given on the shares. It is a token reward paid to the shareholders for their... Maturity
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest... Par Value
Par value is the face value of a bond. Par value is important for a bond or fixed-income instrument because it determines its maturity value as well as the dollar value of coupon payments. The market price of a bond may be above or below par,...
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Related Book For 
Financial Management Theory and Practice
ISBN: 978-0176517304
2nd Canadian edition
Authors: Eugene Brigham, Michael Ehrhardt, Jerome Gessaroli, Richard Nason
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