Textbook: Corporate Finance by Michael Ehrhardt and Eugene Brigham, 5 th edition

Question

Textbook:    Corporate Finance by Michael Ehrhardt and Eugene Brigham, 5th edition

Mini Case 2 – Chapter 9, Questions a, b, h, n, p

During the last few years, Harry Davis Industries has been too constrained by the highcost of capital to make many capital investments. Recently, though, capital costs havebeen declining, and the company has decided to look seriously at a major expansionprogram proposed by the marketing department. Assume that you are an assistant toLeigh 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 berelevant to your task:(1) The firm ’ s tax rate is 40%.(2) The current price of Harry Davis ’ s 12% coupon, semiannual payment, noncallablebonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not useshort-term interest-bearing debt on a permanent basis. New bonds would beprivately placed with no flotation cost.(3) The current price of the firm ’ s 10%, $100 par value, quarterly dividend, perpetualpreferred 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(D 0 ) was $3.12, and dividends are expected to grow at a constant rate of 5.8% inthe foreseeable future. Harry Davis ’ s beta is 1.2, the yield on T-bonds is 5.6%, andthe market risk premium is estimated to be 6%. For the own-bond-yield-plus- judgmental-risk-premium approach, the firm uses a 3.2% risk premium.(5) Harry Davis ’ s 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 Davis ’ sweighted average cost of capital? (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 ’ s debt, and what is the componentcost of this debt for WACC purposes?

h. What is Harry Davis ’ s weighted average cost of capital (WACC)?

n. Explain in words why new common stock that is raised externally has a higherpercentage cost than equity that is raised internally by retaining earnings.

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

Explanation / Answer

a 1.The WACC is used primarily for making long-term capital investment decisions, i.e., for capital budgeting. Thus, the WACC should include the types of capital used to pay for long-term assets, and this is typically long-term debt, preferred stock (if used), and common stock. Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accruals and (2) short-term interest-bearing debt, such as notes payable. If the firm uses short-term interest-bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a short-term debt component. Noninterest-bearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs, that is, net rather than gross working capital is included in capital expenditures.

a 2. Stockholders are concerned primarily with those corporate cash flows that are available for their use, namely, those cash flows available to pay dividends or for reinvestment. Since dividends are paid from and reinvestment is made with after-tax dollars, all cash flow and rate of return calculations should be done on an after-tax basis.

a 3. In financial management, the cost of capital is used primarily to make decisions which involve raising new capital. Thus, the relevant component costs are today's marginal costs rather than historical costs.

b  

Harry Davis’ 12 percent bond with 15 years to maturity is currently selling for $1,153.72. Thus, its yield to maturity is 10 percent:

      0              1              2              3                           29            30

      |       |       |       |     · · ·     |       |

-1,153.72           60            60           60                          60            60

                                                                                                     1,000

Enter n = 30, PV = -1153.72, pmt = 60, and FV = 1000, and then press the i button to find rd/2 = i = 5.0%. Since this is a semiannual rate, multiply by 2 to find the annual rate, rd = 10%, the pre-tax cost of debt.

Since interest is tax deductible, Uncle Sam, in effect, pays part of the cost, and Harry Davis’ relevant component cost of debt is the after-tax cost:

               rd(1 - T) = 10.0%(1 - 0.40) = 10.0%(0.60) = 6.0%.

h.      

WACC= wdrd(1 - T) + wpsrps + wce(rs)

= 0.3(0.10)(0.6) + 0.1(0.09) + 0.6(0.14)

= 0.111 = 11.1%.

n.   

The company is raising money in order to make an investment. The money has a cost, and this cost is based primarily on the investors’ required rate of return, considering risk and alternative investment opportunities. So, the new investment must provide a return at least equal to the investors’ opportunity cost.

If the company raises capital by selling stock, the company doesn’t get all of the money that investors put up. For example, if investors put up $100,000, and if they expect a 15 percent return on that $100,000, then $15,000 of profits must be generated. But if flotation costs are 20 percent ($20,000), then the company will receive only $80,000 of the $100,000 investors put up. That $80,000 must then produce a $15,000 profit, or a 15/80 = 18.75% rate of return versus a 15 percent return on equity raised as retained earnings.

p.    

1.         Don’t use the coupon rate on a firm’s existing debt as the pre-tax cost of debt. Use the current cost of debt.

                  2.   When estimating the risk premium for the CAPM approach, don’t subtract the current long-term t-bond rate from the historical average return on stocks.

                              For example, the historical average return on stocks has been about 12.7%. If inflation has driven the current risk-free rate up to 10%, it would be wrong to conclude that the current market risk premium is 12.7% - 10% = 2.7%. In all likelihood, inflation would also have driven up the expected return on the market. Therefore, the historical return on the market would not be a good estimate of the current expected return on the market.

                  3.   Don’t use book weights to estimte the weights for the capital structure. Use the target capital structure to determine the weights for the WACC. If you don’t have the target weights, then use market value rather than book value to obtain the weights. Use the book value of debt only as a last resort.

                  4.   Always remember that capital components are sources of funding that come from investors. If it’s not a source of funding from an investor, then it’s not a capital component.

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