Download D 1

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