During the last few years, Harry Davis Industries has been too constrained by th
ID: 2680629 • Letter: D
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 proposed by the marketing department. Assume that you are an assistance to Leigh Jones, the finanical vice president. Your first tak is to testimate Harry Davis's cost of cpital. Jones has procided you with the following data, which she believe may be relecant 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 reamining to maturity is $1,153.72. Harry Davids 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 issues.
4.) Harry Davis's common stock is currently sellings at $50/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 over-own-bond-yield-plus judgetmental-risk-premium approach, the firm uses a 3.2% risk premium.
5.) Harry Davis's target capital structure is 30% long debt, 10% preferred stock, and 60% commong equity.
a.) What sources of capital should be included when you estimate Harry Davis's WACC?
Should the componenent costs be figured on a before-tax or an after tax basis?
Should the costs be historical costs or new costs?
b.) What is the market interest rate on Harry Davis's debt, and what is the component cost of this debt for WACC purposes?
c.) What is the firm's cost of preferred stock?
Harry Davis's 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?
d.) What are the two primary ways companies raise common equity?
Why is there a cost associated with reinvested earnings?
Harry Davis doesn't plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis's estiamted cost of equity?
e.) What is the estimated cost of equity using the discounted cash flow approach?
Suppse the firm has historically earned 15% on equity and has paid out 62% of earnings, and supposed investors expect similar values to obtain the future. How could you use this information to estimate the furture dividend growth rate, and what growth rate would you get? Is this consistent with the 5.8% growth rate given earlier? Could the DCF method be applied if the growth rate were not constant? How?
f.) What is the cost of equity based on the over-own-bond-yield-plus-judgmental-risk-premium mothhod?
g.)What is your final estimate for the cost of equity, rs?
h.) What is Harry Davi's weighted average cost of capital?
Explanation / Answer
a) 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. Should the componenent costs be figured on a before-tax or an after tax basis? 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. Should the costs be historical costs or new costs? 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 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%. c) Since the preferred issue is perpetual, its cost is estimated as follows: rps=D ps/Pn = [0.1($100)/($133.10 - $2.00)] =$10/$111.10 0.090 = 9.0%. Note (1) that flotation costs for preferred are significant, so they are included here, (2) that since preferred dividends are not deductible to the issuer, there is no need for a tax adjustment, and (3) that we could have estimated the effective annual cost of the preferred, but as in the case of debt, the nominal cost is generally used. d) A firm can raise common equity in two ways: (1) by retaining earnings and (2) by issuing new common stock. Why is there a cost associated with reinvested earnings? Management may either pay out earnings in the form of dividends or else retain earnings for reinvestment in the business. If part of the earnings is retained, an opportunity cost is incurred: stockholders could have received those earnings as dividends and then invested that money in stocks, bonds, real estate, and so on. Harry Davis doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis’ estimated cost of equity? Answer: rs = 0.07 + (0.06)1.2 = 14.2%. e) [(4.19x 1.05)/50] +.05 = 13.8%. Suppse the firm has historically earned 15% on equity and has paid out 62% of earnings, and supposed investors expect similar values to obtain the future. Another method for estimating the growth rate is to use the retention growth model: g = (1 - Payout Ratio)ROE In this case g = (0.38)0.15 = 5.7%. This is consistent with the 5% rate given earlier. Could the DCF method be applied if the growth rate was not constant? How? yes, you could use the DCF using nonconstant growth. You would find the PV of the dividends during the nonconstant growth period and add this value to the PV of the series of inflows when growth is assumed to become constant. f) rs = company’s own bond yield + risk premium. First find the YTM of the bond: Enter n = 30, PV = -1153.72, pmt = 60, and FV = 1000, and then press the i button to find r/2 = i = 5%. Since this is a semiannual rate, multiply by 2 to find the annual rate, r = 10%. The assumed risk premium is 4%, thus rs = 0.10 + 0.04 = 14%. g) The final estimate for the cost of equity would simply be the average of the values found using the above three methods. CAPM 14.2% DCF 13.8 BOND YIELD + R.P. 14.0 AVERAGE= (14.2+13.8+14)/3= 14% 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%.
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