Textbook: Corporate Finance by Michael Ehrhardt and Eugene Brigham, 5^th edition

Mini Case 2 Chapter 9, Questions a, b, h, n, p

During the last few years, Harry Davis Industries has been too constrained by the highcost of capital to make many capital investments. Recently, though, capital costs havebeen declining, and the company has decided to look seriously at a major expansionprogram proposed by the marketing department. Assume that you are an assistant toLeigh 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 berelevant to your task:(1) The firm s tax rate is 40%.(2) The current price of Harry Davis s 12% coupon, semiannual payment, noncallablebonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not useshort-term interest-bearing debt on a permanent basis. New bonds would beprivately placed with no flotation cost.(3) The current price of the firm s 10%, $100 par value, quarterly dividend, perpetualpreferred stock is $116.95. Harry Davis 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(D 0 ) was $3.12, and dividends are expected to grow at a constant rate of 5.8% inthe foreseeable future. Harry Davis s beta is 1.2, the yield on T-bonds is 5.6%, andthe market risk premium is estimated to be 6%. For the own-bond-yield-plus- judgmental-risk-premium approach, the firm uses a 3.2% risk premium.(5) Harry Davis s target capital structure is 30% long-term debt, 10% preferred stock,and 60% common equity.To help you structure the task, Leigh Jones has asked you to answer the following questions.

a. (1) What sources of capital should be included when you estimate Harry Davis sweighted average cost of capital? (2) Should the component costs be figured on a before-tax or an after-tax basis?(3) Should the costs be historical (embedded) costs or new (marginal) costs?

b. What is the market interest rate on Harry Davis s debt, and what is the componentcost of this debt for WACC purposes?

h. What is Harry Davis s weighted average cost of capital (WACC)?

n. Explain in words why new common stock that is raised externally has a higherpercentage cost than equity that is raised internally by retaining earnings.

p. What four common mistakes in estimating the WACC should Harry Davis avoid?