During the past few years, Harry Davis Industries (HDI) has beenconstrained by high cost of capital to make many capitalinvestments. Recently, though, capital costs have been decliningand the company has decided to look seriously at a major expansionprogram that had been proposed by the marketing department. Assumethat you are an assistant to the CFO. Your first task is estimateHDIâs cost of capital. The CFO has provided you with the followingdata, which is considered to your task:
- The current price of HDIâs 12% coupon , seminal annual,non-callable bonds with 15 years to maturity is $1153.72. HDI doesnot use short-term interest bearing debt on a permanent basis. Newbonds would be privately placed with no flotation costs.
- The current price of HDIâs 10%, $100 par value, quarterlydividend, perpetual preferred stock is $113.10. HDI would incurflotation cost of $2.00 per share.
- HDIâs common stock is currently selling for $50 per share. Itslast dividend (d0) was $4.19, and dividends are expectedto grow at a constant rate of 5% in the foreseeable future. HDIâsbeta is 1.2; the yield on T-Bonds is 7%; and the market riskpremium is estimated to be 6%. For the bond-yield-plus-risk-premiumapproach, the firm uses a 4% point risk premium.
- HDIâs target capital structure:30% long-term, 10% pref. stock,and 60% common equity.
- The firmâs tax rate is 40%
To structure the task somewhat, CFO has asked you to answer thefollowing questions:
1. The after-tax cost of HDIâs debt, Kdis ___________
2. The firmâs cost of preferred stock,Kp, is __________
3. Using CAPM the firmâs cost of equity,Ke is _______
4. The estimated cost of equity using DiscountedCash Flow (DCF) model is ______
5. The cost of equity, Ke, based on thebond-yield-plus-risk-premium method is ____
6. The overall cost of equity, Ke is__________
7. The weighted average cost of capital (WACC) is_________
8. HDI estimates that if it issues new common stock,the flotation cost will be 15%. HDI incorporates theflotation costs into the DCF approach. The estimatedcost of newly issued common stock, taking into account theflotation cost is _________
9. Suppose HDI has historically earned 15% on equity (ROE) andretained 35% of earnings, and investors expect this situation tocontinue in the future. How could you use this information toestimate the future dividend growth rate, and what growth ratewould you get? Is thisconsistent with the 5% growth rate given?
HDI is interested in establishing a new division, which willfocus primarily on developing new internet-based projects. Intrying to determine the cost of capital for this new division, youdiscover that stand-alone firms involved in similar projects haveon average the following characteristics:
- Capital structure of 10% debt and 90% equity.
- Cost of debt of 12% and beta of 1.7.
10. Given this information, your estimate of the divisionâs costcapital is _______
During the past few years, Harry Davis Industries (HDI) has beenconstrained by high cost of capital to make many capitalinvestments. Recently, though, capital costs have been decliningand the company has decided to look seriously at a major expansionprogram that had been proposed by the marketing department. Assumethat you are an assistant to the CFO. Your first task is estimateHDIâs cost of capital. The CFO has provided you with the followingdata, which is considered to your task:
- The current price of HDIâs 12% coupon , seminal annual,non-callable bonds with 15 years to maturity is $1153.72. HDI doesnot use short-term interest bearing debt on a permanent basis. Newbonds would be privately placed with no flotation costs.
- The current price of HDIâs 10%, $100 par value, quarterlydividend, perpetual preferred stock is $113.10. HDI would incurflotation cost of $2.00 per share.
- HDIâs common stock is currently selling for $50 per share. Itslast dividend (d0) was $4.19, and dividends are expectedto grow at a constant rate of 5% in the foreseeable future. HDIâsbeta is 1.2; the yield on T-Bonds is 7%; and the market riskpremium is estimated to be 6%. For the bond-yield-plus-risk-premiumapproach, the firm uses a 4% point risk premium.
- HDIâs target capital structure:30% long-term, 10% pref. stock,and 60% common equity.
- The firmâs tax rate is 40%
To structure the task somewhat, CFO has asked you to answer thefollowing questions:
1. The after-tax cost of HDIâs debt, Kdis ___________
2. The firmâs cost of preferred stock,Kp, is __________
3. Using CAPM the firmâs cost of equity,Ke is _______
4. The estimated cost of equity using DiscountedCash Flow (DCF) model is ______
5. The cost of equity, Ke, based on thebond-yield-plus-risk-premium method is ____
6. The overall cost of equity, Ke is__________
7. The weighted average cost of capital (WACC) is_________
8. HDI estimates that if it issues new common stock,the flotation cost will be 15%. HDI incorporates theflotation costs into the DCF approach. The estimatedcost of newly issued common stock, taking into account theflotation cost is _________
9. Suppose HDI has historically earned 15% on equity (ROE) andretained 35% of earnings, and investors expect this situation tocontinue in the future. How could you use this information toestimate the future dividend growth rate, and what growth ratewould you get? Is thisconsistent with the 5% growth rate given?
HDI is interested in establishing a new division, which willfocus primarily on developing new internet-based projects. Intrying to determine the cost of capital for this new division, youdiscover that stand-alone firms involved in similar projects haveon average the following characteristics:
- Capital structure of 10% debt and 90% equity.
- Cost of debt of 12% and beta of 1.7.
10. Given this information, your estimate of the divisionâs costcapital is _______
