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 35%.
2. The current price of Harry Davis's 8% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,222.72. 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. Harry Davis's common stock is currently selling at $50 per share. Its last dividend (D0) was $3.50, and dividends are expected to grow at a constant rate of 5.3% in the foreseeable future. Harry Davis's beta is 1.3; the yield on T-bonds is 5.9%; 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.
4. Harry Davis's target capital structure is 40% long-term debt and 60% common equity.
To help you structure the task, Leigh Jones has asked you to answer the following questions.
1. What sources of capital should be included when you estimate Harry Davis's weighted average cost of capital (WACC)?
2. Should the component costs be figured on a before-tax or an after-tax basis?
3. What is the market interest rate on Harry Davis's debt, and what is the component cost of this debt for WACC purposes?
4. What are the two primary ways companies raise common equity?
5. Why is there a cost associated with reinvested earnings?
6. Harry Davis doesn't plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis's estimated cost of equity?
7. What is the estimated cost of equity using the discounted cash flow (DCF) approach?
8. Suppose the firm has historically earned 16% on equity (ROE) and retained 67% 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?
9. Could the DCF method be applied if the growth rate was not constant? How?
10. What is the cost of equity based on the bond-yield-plus-judgmental-risk-premium method?
11. What is your final estimate for the cost of equity, rs?
12. What is Harry Davis's weighted average cost of capital (WACC)?
13. Should the company use the overall, or composite, WACC as the hurdle rate for each of its divisions?
14. 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?