Question

5. Advertising firm Harry Davis Industries has asked you to estimate its weighted average cost of capital. To that end, they have provided you with the following information: Tax rate is 40% Harry Davis can issue bonds with a 12% semiannual coupon, a $1000 par value, and a 15 year maturity, at a price of $1153.72 net of floatation costs. The firm has no preferred stock. The firm's common stock is currently selling at a price of $50 per share. The most recent dividend was $3.12, and dividends are expected to grow at a constant annual rate of 5.8%. Harry Davis's beta is 1.2, the yield on treasury securities is 5.6%, and the market risk premium is 6%. For the bond-yield- plus-risk-premium method, Harry Davis uses a company risk premium of 3.2%. The firm's target capital structure is 30% debt, 70% common equity. a. Compute the firm's after-tax cost of debt. b. Compute the firm's cost of equity. C. Compute the firm's weighted average cost of capital. d. Harry Davis is interested in establishing a new division focused on developing web-based content. This division is expected to have a beta of 1.7. It will have the same capital structure as the reset of the firm, and debt will have the same cost as for the rest of the firm. Estimate the cost of capital for this new division

Answer 1

Please refer to the following screenshots showing calculations for each part:

Part a.

Parta To find cost of debt, we first need to find the yield of the bonds This can be done using the RATE function as: Yield to maturity =RATE(15*2 (years*2) ,-60 (semiannual coupon payment), 1153.72 (present value=bond price)) 10.00% So after tax cost of debt = yield (1-tax rate) =10% *(1-40%) 6.00%

Part b.

Part b Cost of equty using dividend growth model Price of share= dividend= 3.12 dividend growth rate 5.80% Next dividend (D1)=3.12 *(1+5.8%) 3.30 Cost of equty using dividend growth model =(D1 / share price ) + growth rate =3.3/50 +5.8% 12.40% Cost of equity using CAPM Rf Beta Market risk premium 5.60% 1.2 6% Cost of equity=Rf + Beta*(Risk premium) =5.6% +1.2*(6%) 12.80% Cost of equity using bond-yield-plus-risk-premium method As per this method, cost of equity= Bond yield + risk premium =10% +3.2% 13.200% Average Cost of equity =(12.4% +12.8% + 13.2%)/3 12.80%

Part c.

Part Weighted average cost of capital = Cost of equity * Weight of equity + after tax cost of debt"Weight of debt = 12.8% * 70% +6% * 30% 10.76%

Part d.

Part d For this division, the cost of equity using CAPM will be different as below: Cost of equity=Rf + Beta*(Risk premium) =5.6% +1.7*(6%) 15.80% So the average cost of equity will be =(12.4% + 15.8% + 13.2%)/3 13.80% Thus the WACC will be= = Cost of equity * Weight of equity+after tax cost of debt*Weight of debt =13.8% * 70% +6% * 30% 11.46%