Harry Davis is interested in establishing a new division, which will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that stand-alone firms involved in similar projects have on average the following characteristics:
(1) Their capital structure is 10% debt and 90% common equity;
(2) Their cost of debt is typically 12% and
(3) They have a beta of 1.7. Given this information, what would your estimate be for the division’s 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 he relevant to your task:
(1) The firm’s tax rate is 40%.
(2) 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.
(3) The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harry Davis’s would incur flotation costs equal to 5% of the proceeds on a new issue.
(4) Harry Davis’s common stock is currently selling at $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rare of 5% in the foreseeable future. Harry Davis’s beta is 1.2, the yield on T- bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus risk-premium approach, the firm uses a 4 percentage point risk premium.
(5) Harry Davis’s target capital structure is 30% long-term debt, 10% preferred stock, and 60°/o common equity.
To structure the task somewhat, Jones has asked you to answer the following questions.