CAPM:
We would use rRF = T-bond rate = 10%. For RPM, we would use 4.5% to 5.5%. For beta,
we would use a beta in the 1.3 to 1.7 range. Combining these values, we obtain this
range of values for rs:
DCF:
The company seems to be in a rapid, non-constant growth situation, but we do not have
the inputs necessary to develop a non-constant rs. Therefore, we will use the constant
growth model but temper our growth rate; that is, think of it as a long-term average g that
may well be higher in the immediate future than in the more distant future.
We could use as a growth estimator this method:
One could look at a range of yields, based on P in the range of $17 to $23, but
because we believe in efficient markets, we would use P0 = $20. Thus, the DCF model
suggests a rs in the range of 15.6% to 20.6%:
Generalized risk premium:
Answers and Solutions: 11 – 14
Based on the three midpoint estimates, we have rs in this range:
Step 3.
Calculate the WACC:
Answers and Solutions: 11 – 15
SPREADSHEET PROBLEM
11-18 The detailed solution for the problem is available in the file Ch11 P18 Build a Model
Answers and Solutions: 11 – 16
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, noncallable
3. The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual
4. Harry Davis’s common stock is currently selling at $50 per share. Its last dividend (D0)
was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the
5. Harry Davis’s target capital structure is 30% long–term debt, 10% preferred stock, and
60% common equity.
a. 1. What sources of capital should be included when you estimate Harry Davis’s
weighted average cost of capital (WACC)?
Answer: 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
a. 2. Should the component costs be figured on a before–tax or an after-tax basis?
Answer: Stockholders are concerned primarily with those corporate cash flows that are
a. 3. Should the costs be historical (embedded) costs or new (marginal) costs?
Answer: In financial management, the cost of capital is used primarily to make decisions
Mini Case: 11 – 18
b. What is the market interest rate on Harry Davis’s debt, and what is the
component cost of this debt for WACC purposes?
Answer: Harry Davis’s 12% bond with 15 years to maturity is currently selling for $1,153.72.
Thus, its yield to maturity is 10%:
Optional Question
Should flotation costs be included in the estimate?
Answer: The actual component cost of new debt will be somewhat higher than 6% because the
Mini Case: 11 – 19
Optional Question
Should you use the nominal cost of debt or the effective annual cost?
Answer: Our 10% pre–tax estimate is the nominal cost of debt. Since the firm’s debt has
semiannual coupons, its effective annual rate is 10.25%:
c. 1. What is the firm’s cost of preferred stock?
Answer: Since the preferred issue is perpetual, its cost is estimated as follows:
c. 2. 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? (Hint: Think about taxes.)
Answer: Corporate investors own most preferred stock, because 70% of preferred dividends
d. 1. What are the two primary ways companies raise common equity?
Answer: A firm can raise common equity in two ways: (1) by retaining earnings and (2) by
Mini Case: 11 – 20
d. 2. Why is there a cost associated with reinvested earnings?
Answer: Management may either pay out earnings in the form of dividends or else retain
d. 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?
e. 1. What is the estimated cost of equity using the discounted cash flow (DCF)
approach?
e. 2. Suppose the firm has historically earned 15% on equity (ROE) and retained
62% 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 5.8% growth
rate given earlier?
Answer: Another method for estimating the growth rate is to use the retention growth model:
e. 3. Could the DCF method be applied if the growth rate was not constant? How?
Answer: Yes, you could use the DCF using nonconstant growth. You would find the PV of the
Mini Case: 11 – 21
f. What is the cost of equity based on the bond–yield–plus–judgmental–risk–
premium method?
Answer: rs = Company’s own bond yield + judgmental risk premium.
g. What is your final estimate for the cost of equity, rs?
Answer: The final estimate for the cost of equity would simply be the average of the values
h. What is Harry Davis’s weighted average cost of capital (WACC)?
i. What factors influence a company’s WACC?
Answer: There are factors that the firm cannot control and those that they can control that
influence WACC.
Mini Case: 11 – 22
j. Should the company use the overall, or composite, WACC as the hurdle rate for
each of its divisions?
Answer: No. The composite WACC reflects the risk of an average project undertaken by the
k. What procedures can be used to estimate the risk–adjusted cost of capital for a
particular division? What approaches are used to measure a division’s beta?
Answer: The following procedures can be used to determine a division’s risk-adjusted cost of
capital:
(1) Subjective adjustments to the firm’s composite WACC.
Mini Case: 11 – 23
l. Harry Davis is interested in establishing a new division that will focus primarily
on developing new Internet–based projects. In trying to determine the cost of
capital for this new division, you discover that specialized firms involved in
similar projects have on average the following characteristics:
• Their capital structure is 10% debt and 90% common equity.
• Their cost of debt is typically 12%.
• The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of
capital?
Answer:
rs DIV. = rRF + (rM – rRF)bDIV.
= 5.6% + (6%)1.7 = 15.8%.
m. What are three types of project risk? How can each type of risk be considered
when thinking about the new division’s cost of capital?
Answer: The three types of project risk are:
Mini Case: 11 – 24
n. Explain in words why new common stock that is raised externally has a higher
percentage cost than equity that is raised internally as retained earnings.
Answer: The company is raising money in order to make an investment. The money has a
cost, and this cost is based primarily on the investors’ required rate of return,
o. 1. Harry Davis estimates that if it issues new common stock, the flotation cost will
be 15%. 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?
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?
p. What four common mistakes in estimating the WACC should Harry Davis
avoid?
Answer: 1. Don’t use the coupon rate on a firm’s existing debt as the pre-tax cost of debt.
Use the current cost of debt.
2. When estimating the risk premium for the CAPM approach, don’t subtract the
Mini Case: 11 – 26