Question

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 proposed by the marketing department. Mary Simpson who is an assistant to Leigh Jones, the financial vice president is asked to estimate Harry Davis’s cost of capital. Jones provides Simpson with the following data.

1. The firm’s tax rate is 40%.

2. The firm has 10% annual coupon bonds with 15 years remaining to maturity. The current price of the bond is $1, 096.26. The bond’s yield-to-maturity is 8.82%.

3. The firm’s balance sheet shows $100 million long-term debt and $300 million common equity.

Simpson estimates the market risk premium as the historical average return on stocks minus the current return on Treasury bonds and obtains a 15.4% of the cost of common stock based on the CAPM.

Simpson calculates the firm’s weighted average cost of capital (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. Find problems inherent in Simpson’s WACC calculation.

2. What can you suggest to solve problems found in Question 1?

3. Simpson used the CAPM to estimate the cost of common stock. What can you propose to get the best estimate for the cost of common stock?

4. How confident can you be with the WACC based on solutions you suggested through the evaluative process in terms of the firm’s divisions and projects? What issues should be considered?

Answer 1

1. Find problems inherent in Simpson’s WACC calculation.

There are two problems inherent in Simpson's WACC calculation. They are:

a] The coupon rate of the bonds has been used as the before tax cost of debt. The cost of debt should be YTM*(1-t) = 8.82%*(1-40%) = 5.29%.

b] The book value weights of debt and equity have been used to calculate WACC. Tbe proper proportion is the weights based on market value weights.

To calculate market value weights the number of shares and the price of shares are not given. The market value of debt would be 100*109.626% = $109.626 m.

2. What can you suggest to solve problems found in Question 1?

The cost of debt should be taken as 5.29% [after tax cost of debt] and the market value weights should be used to find the WACC.

3. Simpson used the CAPM to estimate the cost of common stock. What can you propose to get the best estimate for the cost of common stock?

In addition to the estimate per CAPM. the Dividend discount formula can be used to get an alternative figure for cost of equity. The best estimate of the cost of equity would be the average of the cost of equity per CAPM and the cost of equity per DDM.

4. How confident can you be with the WACC based on solutions you suggested through the evaluative process in terms of the firm’s divisions and projects? What issues should be considered?

The WACC so calculated should be used only for those projects that have the same risk as the existing projects of the firm have, If the project or projects being evaluated have risks different from the risk of the existing projects, then the WACC should be increased or decreased to reflect the change in risk.