During the last few years, Harry Davis Industries has beentoo constrained by the high cost of capital to make many capital investments.Recently, though, capital costs have been declining, and the company hasdecided to look seriously at a major expansion program proposed by themarketing department. Mary Simpson who is an assistant to Leigh Jones, thefinancial vice president is asked to estimate Harry Davis’s cost of capital.Jones provides Simpson with the following data.
1. Thefirm’s tax rate is 40%.
2. Thefirm has 10% annual coupon bonds with 15 years remaining to maturity. Thecurrent price of the bond is $1, 096.26. The bond’s yield-to-maturity is 8.82%.
3. Thefirm’s balance sheet shows $100 million long-term debt and $300 million commonequity.
Simpson estimates the market risk premium as the historicalaverage return on stocks minus the current return on Treasury bonds and obtainsa 15.4% of the cost of common stock based on the CAPM.
Simpson calculates the firm’s weighted average cost ofcapital (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. Findproblems inherent in Simpson’s WACC calculation.
2. Whatcan you suggest to solve problems found in Question 1?
3. Simpsonused the CAPM to estimate the cost of common stock. What can you propose to getthe best estimate for the cost of common stock?
4. Howconfident can you be with the WACC based on solutions you suggested through theevaluative process in terms of the firm’s divisions and projects? What issuesshould be considered?
