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A) What sources of capital should be included when you estimate BHH’s weighted average cost of capital (WACC)? All capital resources are included when calculating WACC such as : • Common stocks • Preferred stocks • Bonds. B) What is the market interest rate on BHH’s debt and its component cost of debt? The current price of BHH’s 12 percent coupon, semiannual payment, bonds with 10 years remaining to maturity is $1,140.00. Bonds have negligible amount of flotation costs. PMT = 12% = 60 ( (12% / 2) X 1,000) FV = 1,000 N = 10 X 2 = 20 PV = ـ1,140 1/Y = ? = 4.9 since the interest is tax deductible: 4.9 (1- 0.3) = 3.43 C) BHH does not plan to issue new shares of common stock. Using the CAPM approach, what is the BHH’s estimated cost of equity? BHH’s beta is 1.30; the yield on T-Bonds is 7 percent; the market return is estimated to be 13%. ke = krf + b (km ـkrf ) where: ke = the required return on security krf = the risk-free rate of interest b = the beta of security j km = the return on the market index Ke = 0.07 + 1.30 ( 0.13 ـ0.07) = 0.15 D) What is the estimated cost of equity using the constant dividend growth model? BHH’s Its last dividend (D0) was $4.19 and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future where: ke = D1 D0 + g ke = cost of equity D1= dividend at the end of the period D0= current stock price g = growth rate D1 = D 0 ( 1 + g ) D1 = 4.19 (1 + 0.05) = 4.40 Ke = (4.40 / 4.19) + 0.05 = 1.10 E) What is BHH’s WACC? • BHH’s target capital structure is 30 percent long term debt, 20 percent preferred stock, and 50 percent common equity • The firm’s tax rate is 30 percent • BHH would incur flotation costs of $2.00 per share on a new issue. WACC = Wd(Kd) (1 ـT) + We(Ke) + Wp(Kp) Where: Wd = the weight of debt Kd = cost of debt T = tax rate We= the weight of equity Ke= cost of equity Wp= the weight of preferred stock Kp= cost of preferred stock E) What is BHH’s WACC? 30% 30% 50% 20% WACC = Wd(Kd) (1 ـT) + We(Ke) + Wp(Kp) 4.9 (from B) 1.10 (from D) 0.15 (from C) ? E) What is BHH’s WACC? Kp = Where: Dp Pp ـF Kp= cost of preferred stock Dp= dividend on preferred stock Pp= Price of preferred stock F= Floatation • The current price of the firm’s 10 %, $100 par value • dividend paid quarterly • preferred stock is $113.10 • flotation costs of $2.00 per share Dp = 2.5 ( ( 10% / 4 ) X 100) Pp = 113.1 F=2 Kp = 2.5 / ( 113.1 ـ2 ) = 0.02 E) What is BHH’s WACC? 30% 30% 50% 20% WACC = Wd(Kd) (1 ـT) + We(Ke) + Wp(Kp) 4.9 (from B) 1.10 (from D) 0.15 (from C) WACC = 0.3 (4.9) (1 ـ0.3) + 0.5 (1.10) + 0.2 (0.02) = 1.03 + 0.55 + 0.004 = 1.58 WACC = 0.3 (4.9) (1 ـ0.3) + 0.5 (0.15) + 0.2 (0.02) = 1.03 + 0.08 + 0.004 = 1.11 0.02 F) • As the firm's Weighted Average Cost of Capital (WACC) reaches its minimum level, the maximum stock price occurs. A company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing. The minimum WACC occurs at the same Debt and equity ratio that maximizes the firm value. The stock price is optimized at the maximum firm value. The firm reaches its Maximum value at the Optimal Debt/Equity ratio for this firm. G) As a financial analyst, what could be your suggestion to reduce WACC? • The Company could lower its WACC, by increase its use of cheaper financing sources. For example, BHH Inc could issue more bonds instead of stocks so, the proportion of debt to equity will increase because the debt is cheaper than the equity so, the company's weighted average cost of capital would decrease. • But only to a certain point because too much debt will make the company more risky and will cause the stock component of WACC increase. Thank you References: • Boehme.R, Corporate Finance, Limits to the Use of Dept Policy. P.4. – http://www.rdboehme.com/MBA_CF/Chap_16.pdf