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 had 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’ 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 percent.

2. The current price of Harry Davis’ 12 percent 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 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10.  Harry Davis would incur flotation costs of $2.00 per share on a new issue.

4. Harry Davis’ common stock is currently selling at $50 per share.  Its last dividend (d0) was $4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future.  Harry Davis’ beta is 1.2; the yield on t-bonds is 7 percent; and the market risk premium is estimated to be 6 percent.  For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.

5. Harry Davis’ target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent 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’ weighted average cost of capital (WACC)?

a. 2.Should the component costs be figured on a before-tax or an after-tax basis?

a. 3. Should the costs be historical (embedded) costs or new (marginal) costs?

b. What is the market interest rate on Harry Davis’ debt and its component cost of debt?

Should flotation costs be included in the estimate?

Should you use the nominal cost of debt or the effective annual cost?

c. 1.What is the firm's cost of preferred stock?

c. 2.Harry Davis’ 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?

d. 2. Why is there a cost associated with reinvested earnings?

d. 3. Harry Davis doesn’t plan to issue new shares of common stock.  Using the CAPM approach, what is Harry Davis’ estimated cost of equity?

e. 1. What is the estimated cost of equity using the discounted cash flow (DCF) approach?

e. 2. Suppose the firm has historically earned 15 percent on equity (ROE) and retained 35 percent 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 percent growth rate given earlier?

e. 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-risk-premium method?

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

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

i. What factors influence Harry Davis’ composite WACC?

j. Should the company use the composite WACC as the hurdle rate for each of its projects?

k. What procedures are used to determine the risk-adjusted cost of capital for a particular division?  What approaches are used to measure a division’s beta?

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

Their capital structure is 10 percent debt and 90 percent common equity.

Their cost of debt is typically 12 percent.

The beta is 1.7. 

        given this information, what would your estimate be for the  division’s cost of capital?

m. What are three types of project risk?  How is each type of risk used?

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

o. 1. Harry Davis estimates that if it issues new common stock, the flotation cost will be 15 percent.  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?

o. 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 percent, 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?