A: Mini Case
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 40%
(2) The current price of Harry Davis's 12% 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 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 issue.
(4) Harry Davis's 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% in the foreseeable future. Harry Davis's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.
a. (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) Should the costs be historical (embedded) costs or new (marginal) costs?© BrainMass Inc. brainmass.com December 15, 2020, 2:59 pm ad1c9bdddf
1. What sources of capital should be included when you estimate Harry Davis' weighted average cost of capital (WACC)?
You may recall that the WACC is primarily used to help make long-term capital investment decisions. Threfore, the WACC should include the types of capital that are used to pay for long-term assets (typically long-term debt), preferred stock (if it is offered), and common stock (the most common). ...
A look at how to determine the sources of capital when computing the WACC, and two other issues.