Harry Davis is interested in establishing a new division, which will focus primarily on developing new internet-based projects. In trying


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:

• Their capital structure is 10 percent debt and 90 percent common equity.

•Their cost of debt is typically 12 percent.

•The beta is 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 had 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’ cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task: 1.The firm's tax rate is 40 percent. 2.The current price of Harry Davis’ 12 percent coupon, semiannual payment, non-callable 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 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Harry Davis would incur flotation costs of $2.00 per share on a new issue. 4.Harry Davis’ 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 rate of 5 percent in the foreseeable future. Harry Davis’ beta is 1.2; the yield on t-bonds is 7 percent; and the market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium. 5.Harry Davis’ target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity. To structure the task somewhat, Jones has asked you to answer the following questions.
Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on...
When companies need to raise money, issuing bonds is one way to do it. A bond functions as a loan between an investor and a corporation. The investor agrees to give the corporation a specific amount of money for a specific period of time in exchange...
Capital Structure
Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a...
Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...
Cost Of Debt
The cost of debt is the effective interest rate a company pays on its debts. It’s the cost of debt, such as bonds and loans, among others. The cost of debt often refers to before-tax cost of debt, which is the company's cost of debt before taking...
A dividend is a distribution of a portion of company’s earnings, decided and managed by the company’s board of directors, and paid to the shareholders. Dividends are given on the shares. It is a token reward paid to the shareholders for their...
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest...

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Financial management theory and practice

ISBN: 978-0324422696

12th Edition

Authors: Eugene F. Brigham and Michael C. Ehrhardt

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Question Posted: March 24, 2010 02:57:55