Question

HD Ltd has determined its optimal capital structure, which is composed of the following sources and target market value proportions: Source of Capital

Long-term debt 30%

Preferred stock 5%

Common stock equity 65%

Target Market Proportions

(i) Debt: The firm can sell a 10-year, $1,000 par value, 6 percent bond for $1,000.

(ii) Preferred Stock: The firm has determined it can issue preferred stock at $65 per share par value. The stock will pay an $8.00 annual dividend.

(iii) Common Stock: The firm’s common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.45. Additionally, the firm’s marginal tax rate is 40 percent.

(a) Calculate the costs of debt, preferred stock, and equity of HD Ltd.

(b) Calculate HD Ltd.’s weighted average cost of capital (WACC) assuming the firm has exhausted all retained earnings. Why HD Ltd. cannot use firm’s WACC to evaluate its standalone projects, and what are possible remedies to adjust it to suit the standalone projects?

Answer 1

COST OF CAPITAL

Part (a) CALCULATION OF COST OF DEBT

Since there is no redemption value given, we assume that the bonds are perpetual.

The Cost of Debt is calculated using the given formula:

where,

Kd= Cost of Debt

I = Annual Interest Payable

T= Tax rate

Fv= Face value of debt

Interest can be calculated as Coupon rate* Face value

Here, Interest payment= 6% of $1000

=$60

Therefore, Cost of Debt can be calculated as,

Kd = 60(1-0.40)/ 1000

=0.036 or 3.6%

CALCULATION OF COST OF PREFERRED STOCK

Cost of preferred stock can be calculated as:

where,

Kp= cost of preferred stock

PD= Preference dividend

P0= Proceeds on preference stock issue

Therefore,

Kp=8/65

=0.1230 or 12.30%

CALCULATION OF COST OF EQUITY

The cost of equity in a constant Dividend Growth Model can be calculated as:

where,

Ke= Cost of equity

D1= Dividend that the firm is expected to pay

Po= Current price of stock

g= Constant growth rate

Since the constant growth rate is not given in the question, we will have to calculate it using the formula,

Where,

D final= Final dividend paid

D initial= Initial dividend paid

n= Time period between them

Given: D1 i.e expected Dividend= $5.07

Let D0 be the Dividend of current year

This means D(-5) be the Dividend 5 years ago=$3.45

Therefore,

Dividend Growth rate = (5.07/3.45)^1/6 - 1

=[1.469^0.167] - 1

=0.0663 or 6.63%

This implies that,

ke= D1/Po + g

=5.07/40 + 0.066

=0.12675 + 0.066

=0.19275 or 19.275%

Part (b) CALCULATION OF WACC

Given the weights, WACC can be computed as:

Where,

We, Wd and Wp are weights of Equity, Debt and Preference stock respectively

WACC = 0.65* 0.1927 + 0.3*0.036 + 0.05*0.123

WACC= 0.1252 + 0.0108 + 0.0061

WACC= 0.1421 OR 14.21%

WACC is the minimum acceptable rate of return that the firm may use to evalulate its projects, However, if the same rate i.e. WACC is applied to all the projects, it may lead to accpeting the riskier projects and rejecting the low risk projects. Also, WACC is assumed to be taken constant throughout while evaluating the project but in reality, market conditions keep on changing thus having an impact upon cost of capital as well.

Remedies: While calculation of WACC only includes some of the major sources of finance, it must include other sources as well that too have an impact on the cost of capital of a firm like warrants or convertible preference stock. Hd ltd. can also use the risk adjusted WACC which considers to new required rate of return on equity which is the cost of equity to the firm.