Ch 09 Mini Case - 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17...

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Ch 09 Mini Case 5/23/2003 Chapter 9. Mini Case Situation (1) The firm's tax rate is 40% To structure the task somewhat, Jones has asked you to answer the following questions. b. What is the market interest rate on Harry Davis' debt and its component cost of debt? 0 1 2 30 N 30 PV 1,153.72 PMT 60 FV 1000 10% PROBLEM 10% Tax rate 40% (1-Tax rate) x 60% x 10% 6.0% c. (1.) What is the firm's cost of preferred stock? (1.) What is the estimated cost of equity using the discounted cash flow (DCF) approach? 2. Retention Growth Model PROBLEM Find g Payout rate = 65% ROE = 15.00% g = (1-Payout rate)(ROE) g = 35% 15.00% g = 5.25% (3.) Could the DCF method be applied if the growth rate was not constant? How? Step 1: Year 0 1 2 3 4 5 Growth 11% 10% 9% 8% 7% Dividend 2.16 2.40 2.64 2.87 3.10 3.32 Step 2: Price at Year 4 = $42.20 Step 3: Calculated Current Price $32.00 Step 4: 14.9% f. What is the cost of equity based on the bond-yield-plus-risk-premium method? THE BOND-YIELD-PLUS-RISK-PREMIUM APPROACH Equity RP = 4% Bond yield = 10.0% (Equity RP)(Bond yield) 4% 10.0% 14.0% THE COST OF EQUITY ESTIMATE It is common to use several methods to estimate the cost of equity, and then find the average of these methods. Method Cost of Equity 14.2% 13.8% 14.0% 14.0% THE WEIGHTED AVERAGE COST OF CAPITAL PROBLEM h. What is Harry Davis' weighted average cost of capital (WACC)? 30% 6.0% 10% 9.0% WACC = 11.10% 60% 14.0% -Their capital structure is 10 percent debt and 90 percent common equity -Their cost of debt is typically 12 percent. -The beta is 1.7. Given this information, what would your estimate be for the division’s cost of capital? ADJUSTING THE COST OF CAPITAL FOR RISK PROBLEM Risk-free rate 7% Market risk premium 6.0% 17.2% Beta 1.7 Target Debt Ratio 10% 12% Tax Rate 40% WACC = x (1-T) + WACC = 1.2% x 60% + 15.5% WACC = 16.2% check this Division WACC 16.2% Company WACC 11.10% ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTS PROBLEM: Flotation Costs and the Cost of New Equity $50.00 $4.40 g = 5% ÷ + g $4.40 ÷ $50.00 + 5% 13.8% lotation percentage cost (F) = 15% Stock price = $50.00 Net proceeds after flotation costs = (1-F) Net proceeds after flotation costs = $50.00 85% Net proceeds after flotation costs = $42.50 Net proceeds after flotation costs = $42.50 $4.40 g = 5% ÷ Net Proceeds + g $4.40 ÷ $42.50 + 5% 15.4% PROBLEM: Flotation Costs and the Cost of Debt Tax rate = 40% Flotation percentage cost (F) = 2% Par value = $1,000 Maturity payment = $1,000 Pre-tax coupon payment = $100 First, calculate the after-tax coupon payments and the net proceeds after the flotation costs.

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