Cost of Capital, Capital Budgeting and Financial Planning

Topics: Net present value, Internal rate of return, Preferred stock Pages: 17 (4114 words) Published: March 30, 2013
Assignment| Cost of Capital, Capital Budgeting and Financial Planning| Chapter(s)| 9, 10, 12|
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HW Assignments will be uploaded to Kean Blackboard and must be accessed from there. You must work in groups where assigned (or independently if not assigned to groups) on homework assignments. Points are noted against each question. You are required to submit Home Work assignments electronically on Kean Blackboard using MS-Office or other text editor. You are required to complete your assignments as per the due date indicated by the Professor.
Total Points in Assignment: 100
(Points scored will be scaled down to a maximum of 15 towards the final grade)


Part I: Cost of Capital

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 that has been 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: a) The firm's tax rate is 40%.
b) 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. c) 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. d) 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 over-own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3.2%judgmental risk premium. e) 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.

1. What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital (WACC)? Should the component costs be figured on a before-tax or an after-tax basis? Should the costs be historical (embedded) costs or new (marginal) costs? (5 points)

Sources of capital to be included to estimate WACC are
* Long term debt – to be considered after tax
* Preferred stock – to be considered before tax ( preferred stock is not tax deductible) * Common equity – to be considered before tax

When it comes to corporate financing, most firms incorporate tax effects in the cost of capital. For this reason, component costs should be calculated on an after-tax basis.

In financial management the WACC is used primarily to make investment decisions and these decisions hinge on projects expected future returns versus the cost of new or marginal capital that will be used to finance these projects. Thus the relevant cost it marginal cost of new debt to be raised during the planning period

2. What is the market interest rate on Harry Davis’s debt, and what is the component cost of this debt for WACC purposes? (3 points)

Pre -Tax cost of Debt is the YTM in the case of a Bond. The current price of Harry Davis’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72.

We used the RATE function in...
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