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. Mary Simpson who is an assistant to Leigh Jones, the financial vice president is asked to estimate Harry Davis’s cost of capital. Jones provides Simpson with the following data. 1. The firm’s tax rate is 40%. 2. The firm has 10% annual coupon bonds with 15 years remaining to maturity. The current price of the bond is $1, 096.26. The bond’s yield-to-maturity is 8.82%. 3. The firm’s balance sheet shows $100 million long-term debt and $300 million common equity. Simpson estimates the market risk premium as the historical average return on stocks minus the current return on Treasury bonds and obtains a 15.4% of the cost of common stock based on the CAPM. Simpson calculates the firm’s weighted average cost of capital (WACC) as follows: Weight of long-term debt is .25 (=100/400) Weight of common equity is .75 (=300/400) WACC = .25 x 10% x (1 - .4) + .75 x 15.4% = 13.05% 1. Find problems inherent in Simpson’s WACC calculation. 2. What can you suggest to solve problems found in Question 1? 3. Simpson used the CAPM to estimate the cost of common stock. What can you propose to get the best estimate for the cost of common stock? 4. How confident can you be with the WACC based on solutions you suggested through the evaluative process in terms of the firm’s divisions and projects? What issues should be considered?
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. Mary Simpson who is an assistant to Leigh Jones, the financial vice president is asked to estimate Harry Davis’s cost of capital. Jones provides Simpson with the following data. 1. The firm’s tax rate is 40%. 2. The firm has 10% annual coupon bonds with 15 years remaining to maturity. The current price of the bond is $1, 096.26. The bond’s yield-to-maturity is 8.82%. 3. The firm’s balance sheet shows $100 million long-term debt and $300 million common equity. Simpson estimates the market risk premium as the historical average return on stocks minus the current return on Treasury bonds and obtains a 15.4% of the cost of common stock based on the CAPM. Simpson calculates the firm’s weighted average cost of capital (WACC) as follows: Weight of long-term debt is .25 (=100/400) Weight of common equity is .75 (=300/400) WACC = .25 x 10% x (1 - .4) + .75 x 15.4% = 13.05% 1. Find problems inherent in Simpson’s WACC calculation. 2. What can you suggest to solve problems found in Question 1? 3. Simpson used the CAPM to estimate the cost of common stock. What can you propose to get the best estimate for the cost of common stock? 4. How confident can you be with the WACC based on solutions you suggested through the evaluative process in terms of the firm’s divisions and projects? What issues should be considered?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Cost of Debt, Cost of Preferred Stock
This article deals with the estimation of the value of capital and its components. we'll find out how to estimate the value of debt, the value of preferred shares , and therefore the cost of common shares . we will also determine the way to compute the load of every cost of the capital component then they're going to estimate the general cost of capital. The cost of capital refers to the return rate that an organization gives to its investors. If an organization doesn’t provide enough return, economic process will decrease the costs of their stock and bonds to revive the balance. A firm’s long-run and short-run financial decisions are linked to every other by the assistance of the firm’s cost of capital.
Cost of Common Stock
Common stock is a type of security/instrument issued to Equity shareholders of the Company. These are commonly known as equity shares in India. It is also called ‘Common equity
Question
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. Mary Simpson who is an assistant to Leigh Jones, the financial vice president is asked to estimate Harry Davis’s cost of capital. Jones provides Simpson with the following data.
1. The firm’s tax rate is 40%.
2. The firm has 10% annual coupon bonds with 15 years remaining to maturity. The current price of the bond is $1, 096.26. The bond’s yield-to-maturity is 8.82%.
3. The firm’s balance sheet shows $100 million long-term debt and $300 million common equity.
Simpson estimates the market risk premium as the historical average return on stocks minus the current return on Treasury bonds and obtains a 15.4% of the cost of common stock based on the CAPM .
Simpson calculates the firm’s weighted average cost of capital (WACC) as follows:
Weight of long-term debt is .25 (=100/400)
Weight of common equity is .75 (=300/400)
WACC = .25 x 10% x (1 - .4) + .75 x 15.4% = 13.05%
1. Find problems inherent in Simpson’s WACC calculation.
2. What can you suggest to solve problems found in Question 1?
3. Simpson used the CAPM to estimate the cost of common stock. What can you propose to get the best estimate for the cost of common stock?
4. How confident can you be with the WACC based on solutions you suggested through the evaluative process in terms of the firm’s divisions and projects? What issues should be considered?
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