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A B C D E F G H I
12/10/2012
Situation
COST OF DEBT, rd
N30
B-T rd10%
Tax rate 40%
Chapter 9. Mini Case
The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The after-tax
rate is calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate.
To help you structure the task, Leigh Jones has asked you to answer the following questions.
(5) Harry Davis's target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
b. What is the market interest rate on Harry Davis's debt and what is the component cost of this debt for WACC
purposes?
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:
a. (1.) What sources of capital should be included when you estimate Harry Davis's weighted average cost of capital
(WACC)? Answer: See Chapter 9 PowerPoint file.
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A B C D E F G H I
COST OF PREFERRED STOCK, rps
rps =9.0%
Example:
rps 9%
rd10%
T40%
A-T Risk Premium on Preferred 1.92%
COST OF EQUITY (INTERNAL), rs
The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it issues new
preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible.
Corporations own most preferred stock, because 70% of preferred dividends are non-taxable to corporations. Therefore,
preferred stock often has a lower before-tax yield than the before-tax yield on debt. But, the after-tax costs to the issuer
are higher on preferred stock than debt. This is consistent with the higher risks of preferred stock.
(2.) Harry Davis's preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than
the
Preferred stock carries a higher risk to investors than debt. Companies are not required to pay preferred dividends
although, firms typically want to pay preferred dividends. Otherwise, they cannot pay common dividends, so there will be
difficulty raising additional funds, and preferred stockholders may gain control of the firm.
d. (1.) What are the two primary ways companies raise common equity? Answer: See Chapter 9 PowerPoint file.
(2.) Why is there a cost associated with reinvested earnings? Answer: See Chapter 9 PowerPoint file.
(3.) 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?
c. (1.) What is the firm's cost of preferred stock?
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A B C D E F G H I
rs = 5.6% +6.0% 1.2
rs = 5.6% +7.2%
rs = 12.80%
THE DISCOUNTED CASH FLOW APPROACH
e. (1.) What is the estimated cost of equity using the discounted cash flow (DCF) approach?
P0 =$50.00
D0 =$3.12
2. Retention Growth Model
Find g:
Payout rate = 62%
ROE = 15%
BONUS: APPLICATION OF THE DISCOUNTED CASH FLOW APPROACH WHEN GROWTH IS NOT CONSTANT
Step 1:
Suppose a firm's stock trades at $50 and its most recent dividend was $3.12. If the expected constant growth rate is 5.8%,
what is the firm's cost of equity?
Create a time line showing the expected future dividend payments. These are based on the current dividend and the
Suppose the current dividend is $2.16 per share and the current actual price that we observe is $32.00 per share.
Analysts forecast growth of 11% the first year, 10% the second year, 9% the third year, 8% the fourth year, and 7%
thereafter. Estimate the cost of equity.
e. (2.) Suppose the firm has historically earned 15% on equity (ROE) and retained 35% 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% growth rate given earlier?
As we noted earlier, analysts often provide non-constant estimates of future growth. We can use a modification of the
discounted cash flow valuation procedure for non-constant growth from Chapter 5 to estimate the cost of equity.
The simplest DCF model assumes that growth is expected to remain constant, and in this case: rs = D1/P0 + g.
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A B C D E F G H I
Step 3:
Calculated Current Price = $32.00
THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH
Calculate the current price of the stock, based on the estimate of rs below. To do this, find the present value of the price
at Year 4, P4, and then find the present value of the dividends from Year 1 through Year 4. Use the cost of equity, rs,
shown below, as the discount rate.
f. What is the cost of equity based on the over-own-bond-yield-plus-judgmental-risk-premium method?
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A B C D E F G H I
THE COST OF EQUITY ESTIMATE
Method
Cost of Equity
THE WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital (WACC) is calculated using the firm's target capital structure together with its after-
tax cost of debt, cost of preferred stock, and cost of common equity.
It is common to use several methods to estimate the cost of equity, and then find the average of these methods.
h. What is Harry Davis's weighted average cost of capital (WACC)?
i. What factors influence a company’s WACC? Answer: See Chapter 9 PowerPoint file.
j. Should the company use the overall, or composite, WACC as the hurdle rate for each of its division’s? Answer: See
Chapter 10 PowerPoint file.
k. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are
used to measure a division’s beta? Answer: See Chapter 9 PowerPoint file.
g. What is your final estimate for the cost of equity, rs?
This approach consists of adding a judgmental risk premium to the yield on the firm's own long-term debt. It is logical
that a firm with risky, low-rated debt would also have risky, high-cost equity. Historically, we have observed that the risk
premium for equity is in the range of 3 to 5 percentage points. This method provides a ballpark estimate, and it is
generally used as a check on the CAPM and DCF estimates. This method is used primarily in utility rate case hearings.
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A B C D E F G H I
10.38%
ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTS
P0 =$50.00
Net proceeds after flotation costs =
(Stock Price) (1 – F)
Net proceeds after flotation costs =
$50.00 85%
Net proceeds after flotation costs = $42.50
Net proceeds after flotation costs = $42.50
D1 =$3.30
g = 5.8%
PROBLEM: Flotation Costs and the Cost of Debt
Tax rate =
40%
Flotation percentage cost (F) = 2%
m. What are three types of project risk? How is each type of risk used? Answer: See Chapter 9 PowerPoint file.
This indicates that the division's market risk is greater than the firm's average division. Typical projects within this new
division would be accepted if their returns are above the divisional WACC.
Company WACC
o. (2.) Suppose Harry Davis issues 30-year debt with a par value of $1,000 and a coupon rate of 10%, paid annually. If
flotation costs are 2%, what is the after-tax cost of debt for the new bond issue?
Flotation costs are the fees charged by investment bankers plus the accounting and legal expenses associated with the
issuance of new securities. A company cannot use the entire proceeds of a new security issuance, because it must use
some of the proceeds to pay the flotation costs.
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A B C D E F G H I
Net proceeds after flotation costs = $1,000 98%
Net proceeds after flotation costs = $980
Number of coupon payments = N = 30
Now find the rate that the company pays, based on its net proceeds after flotation costs and its after-tax payments.
p. What four common mistakes in estimating the WACC should Harry Davis avoid?
Answer: See Chapter 9 PowerPoint file.
