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 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:

$$ The firm's tax rate is $21\%.$

$$ The current price of Harry Davis$$s $12\%$ coupon, semiannual payment, noncallable bonds with $15$ years remaining to maturity is $$1,153\mathrm{.}72.$ Harry Davis does not use short$-$term interest$-$bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. The firm has $30,000$ bonds outstanding.

$$ The current price of the firm$$s $10\%,$ $$100$ par value, perpetual preferred stock is $$116\mathrm{.}95.$ Harry Davis would incur flotation costs equal to $5\%$ of the proceeds on a new issue.

$$ Harry Davis$$s common stock is currently selling at $$50$ per share. Its last dividend was $$3\mathrm{.}12,$ and dividends are expected to grow at a constant rate of $5\mathrm{.}8\%$ in the foreseeable future. Harry Davis$$s beta is $1\mathrm{.}2$; the yield on T$-$bonds is $5\mathrm{.}6\%$; and the market risk premium is estimated to be $6\%.$ For the over$-$own$-$bond$-$yield$-$plus$-$ judgmental$-$risk$-$premium approach, the firm uses a $3\mathrm{.}2\%$ judgmental risk premium. The company does not plan to issue new shares of common stock.

$$ Harry Davis$$s book value balance sheet is:

Current assets $$40,000,000$ Current liabilities $$10,000,000$

Fixed assets $50,000,000$ Long term debt $30,000,000$

Equity

Preferred stock $(200,000$ shares$)5,000,000$

Common stock $(1$ million shares$)10,000,000$

Retained earnings $35,000,000$

Total assets $$90,000,000$ Total claims $$90,000,000$

$$

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

$1.$ What is the market interest rate $($yield to maturity$)$ on Harry Davis$$s debt, and what is the component cost of this debt for WACC purposes?

$2.$ What is the firm's cost of preferred stock?

$3.$ Harry Davis$$s preferred stock is riskier to investors than its debt, yet the preferred stock's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? $($Hint: Think about taxes.$)$

$4.$ Using the CAPM approach, what is Harry Davis$$s estimated cost of equity?

$5.$ What is the estimated cost of equity using the dividend growth model?

$6.$ Suppose the firm has historically earned $15\%$ on equity $($ROE$)$ and retained $38\%$ 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 $5\mathrm{.}8\%$ growth rate given earlier?

$7.$ What is the cost of equity based on the bond$-$yield$-$plus$-$judgmental$-$risk$-$ premium method?

$8.$ What is your final estimate for the cost of equity, rs$?$

$9.$ What is Harry Davis$$s weighted average cost of capital $($WACC$)?$