Tom Hanks has been appointed as the CFO (Chief Financial Officer) of Holiwood Corporation. As he needs to take some important decisions on future investment projects, he is concerned about the firm's Cost of Capital.                                                                                                            

He has been looking at the firm's financial information and market data in order to figure out the firm's Cost of Capital.                                         

                                                                                                            

Holiwood Inc. has three series of Bonds (long-term debt)                                                                                                

Its first series bonds are currently selling at $1009.00 in the market. There are currently 11.5 million such bonds in the market. These are semi-annual interest paying bonds, with an annual coupon rate of 8%. These bonds will mature in 10 years. The series is quite old and hence the issuing cost is irrelevant.                                                                     

                                                                                                            

Its second series bonds are currently selling at $1059.00 in the market. There are currently 9 million such bonds in the market. These are quarterly interest paying bonds, with an annual coupon rate of 9%. These bonds will mature in 12 years. The series is quite old and hence the issuing cost is irrelevant.                                                                    

                                                                                                            

For the third series, the Yield to Maturity is 9.1% and the estimated issuing cost is 0.8%. Total market value of this bond series is $6.2 billion.                                                                                                                                            

Holiwood Inc.'s effective tax rate is 30%. Interest rate for the short term debt is 4.2%.                                                                                                      

The firm has been paying dividends over the last fifteen years. Last six years' dividend information is presented in Table 1.           

(See the excel worksheet bellow.)                                                                                   

                                          

		2007	2008	2009	2010	2011	2012
Dividend (in $)		2.1	2.45	2.65	2.8	3.1	3.4

                                                      

Holiwood Inc. has currently 165 million common shares outstanding. Current share price is $62 in the market.                                                      

Estimated flotation cost is negligible.                                                                                         

Tom recalls that there are two commonly used methods to calculate the cost of equity - Dividend Growth Model and CAPM.                                                                                             

Tom decides to use the compound growth rate concept, to calculate dividend growth rate (Hint: FV = PV(1+g)^n)                                                                                     

In order to use CAPM, Tom looks for other market data. The beta is 2.0                                                                          

He projects that a reasonable estimate for future risk-free rate will be 4%; the market risk premium is: 6%                 

1. What is the cost of common equity - (i) using DGM (Dividend Growth Model) (ii) using CAPM (Capital asset pricing model)?                                                                                                                                               

2. What is the cost of retained earnings?                                                                                              

                                                                                                

3. What is the after-tax cost of debt? (Show your calculation for each series separately and combined)                                                                                                                                                                            

4. What are the weights for different components of cost of capital?                                                                                                                                                                                          

5. What is the Holiwood Inc.'s overall cost of capital? Use market value weights and calculate the average 'overall cost of capital' using the average of dividend growth model and CAPM for cost of equity.       

 

6. Tom Hanks finds that it is a good time to raise more equity. But he also realizes that more common equity will increase the overall cost of capital (i.e. weighted cost of capital). He wants to make sure that the overall cost of capital (of the firm) does not cross 11%. How much additional common equity he can raise? How many new shares should be issued? (New shares can be issued at the same price).

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ANSWER Here is the stepbystep solution to the problem 1 Cost of Common Equity i Using Dividend Growth Model DGM Dividend Growth Rate g Div2012 Div2007... View the full answer