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Ch 9 Mini Case3/19/2001Chapter 9. Mini CaseSituationDuring the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make manycapital 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 Davis's cost of capital.Jones has provided data that she believes is relevant to your task. (1) The firm's tax rate is 40%(2) The current price of Harry Davis' 12 percent coupon, semiannual payment, noncallable bonds with 15 years remainingto maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bondswould be privately placed with no flotation costs. (3) The current price of the firm's 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10Harry Davis would incur a flotation cost of $2.00 per share on a new issue.(4) Harry Davis' common stock is currently selling at $50 per share. Its last dividend (Do) was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Harry Davis' 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-risk-premium approach,the firm uses a 4 percentage point risk premium.(5) Harry Davis' target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent commonequity.Sources of CapitalLong-term debtPreferred StockCommon EquityThe cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm usesto finance its assets, or its WACC. There is an overall, or corporate, WACC which reflects the average riskinessof all the firm's assets. However, since different assets may have more or less risk than the average, the overallWACC must be adjusted up or down to reflect the riskiness of different proposed capital budgeting projects.Tax effects associated with financing either in capital budgeting cash flows or in costs of capital. Most firms incorporate tax effects in the cost of capital, therefore focus on after-tax costs. After-tax costs only effect the costof debt. This is due to interest on debt being tax deductible.Embedded or Marginal CostsThe cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we shouldfocus on marginal costs.
PROBLEMFind the after-tax cost of debt for a company that pays 10% interest on debt and is subject to a 40% marginal taxrate.COST OF DEBT, kdA 15-year, 12% semiannual bond sells for $1,153.72. What is kd?
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