Financial management

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 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 Daviss 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 Daviss 12% coupon, semi-annual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

3. The current price of the firms 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue.

4. Harry Daviss common stock is currently selling at $50 per share. Its last dividend (D0) was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the foreseeable future. Harry Daviss beta is 1.2; the yield on T-bonds is 5.6%; 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 3.2% judgmental risk premium.

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

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

a.

1. What sources of capital should be included when you estimate Harry Daviss 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 Daviss debt, and what is the component cost of this debt for WACC purposes?

c.

1. What is the firm's cost of preferred stock?
2. Harry Daviss 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? (Hint: Think about taxes.)

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 doesnt plan to issue new shares of common stock. Using the CAPM approach, what is Harry Daviss 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 62% 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 5.8% 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-judgmental-risk-premium method?

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

h. What is Harry Daviss weighted average cost of capital (WACC)?

i. What factors influence a companys WACC?

j. Should the company use the overall, or composite, WACC as the hurdle rate for each of its divisions?

k. What procedures can be used to estimate the risk-adjusted cost of capital for a particular division? What approaches are used to measure a divisions beta?

l. Harry Davis is interested in establishing a new division that will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that specialized firms involved in similar projects have on average the following characteristics:

• Their capital structure is 10% debt and 90% common equity.
• Their cost of debt is typically 12%.
• The beta is 1.7.

Given this information, what would your estimate be for the divisions cost of capital?

m. What are three types of project risk? How can each type of risk be considered when thinking about the new divisions cost of capital?

n. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally as retained earnings.

o.

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 10%, paid annually. If flotation costs are 2%, what is the after-tax cost of debt for the new bond?

p. What four common mistakes in estimating the WACC should Harry Davis avoid?