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 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 bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
(3)? The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue.
(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 foreseeable future. Harry Davis’s beta is 1.2, the yield on T-bonds is 5.6%, and the market risk premium is estimated to be 6%. For the own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3.2% risk premium.
(5) ?Harry Davis’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
To help you structure the task, Leigh Jones has asked you to answer the following questions.
Question 1) What is the estimated cost of equity using the discounted cash flow (DCF) approach?
Question 2)? Suppose the firm has historically earned 15% on equity (ROE) and has paid out 62% of earnings, and suppose investors expect similar values to obtain 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?
Question 3) ?Could the DCF method be applied if the growth rate were not constant? How?
Question 4) What is the cost of equity based on the own-bond-yield-plus-judgmental-risk-premium method?
Question 5) What is your final estimate for the cost of equity, (rs)?
Question 6) What is Harry Davis’s weighted average cost of capital (WACC)?