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Finance case study

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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 Daviss cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task: (1) The firms tax rate is 40 percent. (2) The current price of Harry Daviss 12 percent coupon, semiannual payment, non-callable 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 firms 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 Daviss 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 Daviss 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 Daviss 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 Daviss weighted average cost of capital (WACC)? WACC usually includes the type of capital used to pay for long-term assets such as longterm debt, preferred stock, and common stock. If short term debt is used to acquire fixed assets then it should be included in the calculation of WACC. a. (2) Should the component costs be figured on a before-tax or an after-tax basis? Cash flow and rate of return calculations should be done on an after-tax basis because they are paid after deducting tax.

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a. (3) Should the costs be historical (embedded) costs or new (marginal) costs? The cost of capital is used to make decisions which involve raising new capital, therefore, the relevant costs are considered as marginal costs. b. What is the market interest rate on Harry Daviss debt and its component cost of debt? YTM/2 = (CP + ((FV - VB)/n)) / ((FV + VB)/2) = (60 + ((1,000 1153.72)/30)) / ((1,000 + 1153.72)/2) = 0.05 YTM= rd = 10%

c. (1) What is the firms cost of preferred stock? rps = Dps/Pn = (0.1x100)/(133.10-2.00) = 10/111.10 = 0.090 = 9.0%. c. (2) Harry Daviss preferred stock is riskier to investors than its debt, yet the preferreds 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.) Preferred stocks often have a lower before-tax yield than the before-tax yield on debt. d. (1) What are the two primary ways companies raises common equity? A firm can raise common equity by issuing new common stock and by retaining earnings. d. (2) Why is there a cost associated with reinvested earnings? Earnings may be paid either in dividends or kept as retain earnings for reinvestment, when retained earnings an opportunity cost incurs to the stockholders because they may use those earnings in re-investments in the market. d. (3) Harry Davis doesnt plan to issue new shares of common stock. Using the CAPM approach, what is Harry Daviss estimated cost of equity? rs = 0.07 + (0.06)1.2 = 14.2%. e. (1) What is the estimated cost of equity using the discounted cash flow (DCF) approach? rs = D1/P0 = ((D0(1+g))/P0)+g = ((4.19(1+0.05))/50)+0.05 = 13.8%.

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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? g = (1 - Payout Ratio) x ROE g = (0.35) x 0.15 = 5.25%. It is consistent with the 5% rate given earlier e. (3) Could the DCF method be applied if the growth rate was not constant? How? Yes, one could use the DCF using non constant growth. One would calculate the PV of the dividends during the non-constant growth period and add this value to the PV of the series of inflows during constant growth.

f. What is the cost of equity based on the bond yield-plus-risk-premium method? rs = companys bond yield + risk premium. First find the YTM of the bond: YTM/2 = (CP + ((FV - VB)/n)) / ((FV + VB)/2) = (60 + ((1,000 1153.72)/30)) / ((1,000 + 1153.72)/2) = 0.05 YTM= rd = 10% The assumed risk premium is 4%, consequently rs = 0.10 + 0.04 = 0.14 rs = 14%

g. What is your final estimate for the cost of equity, rs? The final estimate for the cost of equity would simply be the average of the values found using the above three methods. CAPM DCF BOND YIELD + R.P. AVERAGE 14.2% 13.8% 14.0% 14.0%

h. What is Harry Daviss weighted average cost of capital (WACC)? WACC = wdrd (1 - T) + wps (rps) + wce (rs) = 0.3(0.10) (0.6) + 0.1(0.09) + 0.6(0.14) = 0.111 11.1%.

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i. What factors influence a companys WACC? The factors that influence the companys WACC are: -

Rates of Level of Interest, and Tax which the company cannot control. Policies of Capital Structure, Dividends, and Investment which the company can control.

j. Should the company use the composite WACC as the hurdle rate for each of its divisions? No because the WACC represents the hurdle rate of a typical project with average risk. Different projects have different risks; it should be adjusted to reflect the projects risk.

k. What procedures are used to determine the risk adjusted cost of capital for a particular division? What approaches are used to measure a divisions beta? The procedures that can be used to determine a divisions risk-adjusted cost of capital are: - Subjective adjustments to the firm WACC. - To estimate the cost of capital if the division were a stand-alone firm.

The approaches that can be used to measure a divisions beta are: - Pure play approach, to find many publicly traded companies in the same project business. Then, use the average of their betas as a representation for the projects beta. - Accounting beta approach, to run a regression between the project ROA and the S&P index ROA.

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 divisions cost of capital? rs DIV. = rRF + (rM - rRF) bDIV. = 7% + (6%) 1.7 = 0,17 17.2%.

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WACCDIV. = W drd (1 - T) + W crs = 0.1(12%) (0.6) + 0.9(17.2%) = 0.162 16.2%.

The divisions WACC = 16.2% and the corporate WACC = 11.1%. The division market risk is greater than the firm average projects. Projects within this division would be accepted if their returns are above 16.2 percent.

m. What are three types of project risk? How is each type of risk used? The three types of project risk are: Stand-Alone Risk Corporate Risk Market Risk

Market risk is best in most situations, however, creditors, customers, suppliers, and employees are more affected by corporate risk; therefore, corporate risk is also relevant. Stand-alone risk is the easiest type of risk to measure.

n. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings. The company raises money to make investments, the money has a cost that is based on the investors required rate of return, considering risk and alternative investment opportunities; consequently new investments must provide returns that are at least equal to the investors opportunity cost. When a company raises capital by selling stock, it doesnt get all the money that investors put up due to paid flotation.

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? Re = (D0(1+g))/(P0(1-F))+g = (4.19(1.05))/(50(1-0.15))+0.05 = 0.154 15.4%.

o. (2) Suppose Harry Davis issues 30-year debt with a par value of $1,000 and a coupon rate of 10 percent, paid annually. If flotation costs are 2 percent, what is the after-tax cost of debt for the new bond issue? YTM = (CP + ((FV - VB)/n)) / ((FV + VB)/2)

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= (60 + ((1,000 (1000(1-0.02))/30)) / ((1,000 + (1000(1-0.02))/2) = 0.0615 After Tax cost of debt = 6.15% p. What four common mistakes in estimating the WACC should Harry Davis avoid? 1. Dont subtract the current long-term t-bond rate from historical average return on stocks when estimating the risk premium for the CAPM approach,. 2. Avoid using the coupon rate on a firms existing debt as the pre -tax cost of debt. Use the current cost of debt. 3. Remember that capital components are sources of funding that come from investors 4. Use target capital structure to determine the weights of WACC, in case of absence of target weights, then market value may be used; book value of debt may be used in the absence of any other information only.

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