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%
Q1. Find
problems inherent in Simpson’s WACC calculation.
Q2. What
can you suggest to solve problems found in Question 1?
Q3. 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?
Q4. 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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