Case During the past 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 has 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 35%. (2) The current price of Harry Davis's 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's 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's beta is 1.2, the yield on government bonds is 4%, and the market risk premium is estimated to be 5%. For the bondyield-plus-risk-premium approach, the firm uses a 4 percentage 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)? m. Explain 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 dividend growth 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 issue? o. What four common mistakes in estimating the WACC should Harry Davis avoid? (2) Should the component costs be figured on a before-tax or an aftertax basis? (3) Should the costs be historical (embedded) costs or new (marginal) costs? b. What is the market interest rate on Harry Davis's debt and its component cost of debt? 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's estimated cost of equity? e. (1) What is the estimated cost of equity using the dividend growth 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 dividend growth approach 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, rb ? h. What is Harry Davis's 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? I. What are three types of project risk? How is each type of risk used