During the last few years, Harry Davis Industries has been too constrained by th

Question

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:

(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 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 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 Davis's 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 Davis's beta is 1.2, the yield on T-bonds is 5.6%, and the market risk premium is estimated to be 6%. For the own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3.2% judgmental risk premium.
(5) Harry Davis's target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

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 division's beta?

m. What are three types of project risk? How can each type of risk be considered when thinking about the new division's 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 by retaining earnings.

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

Explanation / Answer

K.

Here firm use debt, equity and preferred stocks for the capitalization of firm. Firm have to calculate risk adjusted cost of capital for each equity, debt and preferred stock. In this firm Debt have no flotation cost added in interest rate. Interest rate in a debt include risk free rate, inflation and risk premium. Risk free bonds are government bonds and inflation rate is adjusted with the risk free rate in interest rate. Risk premium exists in the long term bonds having upward sloping yield.

Interest rate=Risk free rate +Inflation rate + Risk Premium

Preferred stocks have floating rate risk in the market. Floating rate is added to the cost of equity of the preferred stock.

Cost of equity includes risk free rate, market risk premium and beta of the firm. Market risk premium is difference between risk free rate and expected return on market portfolio.

Cost of Equity=Risk free rate+ Market risk premium (beta)

Estimated beta is calculated as covariance of security to the market divided by the variance of the market.

Beta=Cov(mkt,stock) /Market variance

m.

Three type of risk are

a. Interest Rate risk: Interest rate risk include inflation rate and risk premium of debt.

b. Market risk included in tthe equity part which may change the rate of market risk preium and beta.

c. Floatition cost adjust security price in the cost of capital calculations.

P.

Common mistakes in WACC

1. Selection of weights in the WACC. Ratio of debt equity should be in a manner to minimize risk and provide maximum return.

2.Selection of long term debt. Long term debt bonds are more risky than short term debt.

3. Wrong leveraging of the firm.

4 Old company estimate of beta using for the calculation.

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