Ch 09 Mini Case5/23/2003Chapter 9. Mini CaseSituation(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?01230N30PV1,153.72 PMT60FV100010%PROBLEM10%Tax rate40%(1-Tax rate)x60%x10%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 ModelPROBLEMFind gPayout 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:Year012345Growth11%10%9%8%7%Dividend2.162.402.642.873.103.32Step 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 APPROACHEquity RP =4%Bond yield =10.0%(Equity RP)(Bond yield)4%10.0%14.0%THE COST OF EQUITY ESTIMATEIt is common to use several methods to estimate the cost of equity, and then find the average of these methods.MethodCost of Equity14.2%13.8%14.0%14.0%THE WEIGHTED AVERAGE COST OF CAPITALPROBLEMh. 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 RISKPROBLEMRisk-free rate7%Market risk premium6.0%17.2%Beta1.7Target Debt Ratio10%12%Tax Rate40%WACC =x(1-T)+WACC =1.2%x60%+15.5%WACC =16.2%check thisDivision WACC16.2%Company WACC11.10%ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTSPROBLEM: Flotation Costs and the Cost of New Equity$50.00$4.40g =5%÷+g$4.40÷$50.00+5%13.8%lotation percentage cost (F) =15%Stock price =$50.00Net 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$4.40g =5%÷Net Proceeds+g$4.40÷$42.50+5%15.4%PROBLEM: Flotation Costs and the Cost of DebtTax 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.