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.
firm’s tax rate is 40%.
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%.
firm’s balance sheet shows $100 million long-term debt and $300 million common
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:
of long-term debt is .25 (=100/400)
of common equity is .75 (=300/400)
= .25 x 10% x (1 - .4) + .75 x 15.4% = 13.05%
problems inherent in Simpson’s WACC calculation.
can you suggest to solve problems found in Question 1?
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?
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?