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fm10 20 - current long-term t-bond rate from the historical...

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o. 1. Harry Davis estimates that if it issues new common stock, the flotation cost will be 15 percent. 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? Answer: 15.4%. = 5.0% + $42.50 $4.40 = 5.0% + 0.15) - $50(1 ) $4.19(1.05 = g + F) - (1 P g) + (1 D = r 0 0 e 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 percent, what is the after-tax cost of debt for the new bond? Answer: Using a financial calculator, n = 30, PV = (1-0.02)(1000) = 980, pmt = -(1-0.40)(100) = -60, FV = -1000. The resulting i is 6.15%, which is the after-tax cost of debt. 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
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Unformatted text preview: current long-term t-bond rate from the historical average return on stocks. For example, the historical average return on stocks has been about 12.7%. If inflation has driven the current risk-free rate up to 10%, it would be wrong to conclude that the current market risk premium is 12.7% - 10% = 2.7%. In all likelihood, inflation would also have driven up the expected return on the market. Therefore, the historical return on the market would not be a good estimate of the current expected return on the market. 3. Don’t use book weights to estimate the weights for the capital structure. Use the target capital structure to determine the weights for the WACC. If you don’t have the target weights, then use market value rather than book value to obtain the weights. Use the book value of debt only as a last resort. Mini Case: 10 - 20...
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