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FINANCIAL MGMT. PRINCIPLES
Section: 203
Case Study
Submitted by:
Aala ALSheddi
ID:201000377
Lujayn Tahlawi
ID:200900797
Fatima ALBagshi ID:200800928
Naema ALYahya
ID: 200800113
23 December 2012
Instructor:
Ms.Rashida Sharmin
A. What sources of capital should be included when you estimate BHH’s weighted
average cost of capital (WACC)?
Weighted Average Cost of Capital (WACC) is the average cost to a company of the
funds it has invested in the assets of the company. This is composed of a possible
combination of debt, preferred shares, common shares and retained earnings. All
components of the cost of capital are determined at the current market rates. It used
mainly for making long-term capital investment decisions.
Capital can be acquired from four possible sources to pay for long-term assets:
(1) Debt is borrowed from banks, insurance companies, governments and through the
issuance of bonds to investors. The cost of debt is determined by the interest rate
paid to the supplier of these funds.
(2) Preferred shares are similar to debt in that the owners of the preferred shares are
paid a regular fixed payment, like an interest payment. Unlike debt, the preferred
shares are never repaid, the shares remain outstanding indefinitely, and the
dividend payments are made for as long as the shares remain outstanding.
(3) Common equity is acquired by a firm when they sell shares to the public. The
holders of the shares expect to be compensated for the use of their capital, as well
as the risk they take by investing directly in the company as an owner.
(4) Retained earnings are acquired by a company from the profits it generates
through its operations. The retained earnings are assumed to be the equity of the
shareholders that have been reinvested in the company rather than paid out
through dividends.
The sources of capital to pay for short-term assets:
(1) spontaneous are liabilities that result from the purchasing of goods or services on
credit incur the obligation to later pay for these goods or services at some time in
future such as account payable and accrued liabilities.
(2) Interest-bearing debt is investments such as bonds and certificates of deposit that
pay regular, periodic interest.
B. What is the market interest rate on BHH’s debt and its component cost of debt?
N=20
PV= -1,140.00
PMT= 0.12*1,000=120\2=60
FV=1000
I=4.89
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?
K j = K rf + B ( Km –K rf)
= .07 + 1.3 (.13-.07)
= 14.8 %
D. What is the estimated cost of equity using the constant dividend growth model?
D (1+g) / Res – g = 4.19 (1+.05) / .13 - .05
= 4.3995 / .08 = 54.99
E. What is BHH’s WACC?
WACC = [rD *( WD )*(1- Tc )] + [ rp*( Wp )] + [ rE*( WE )]
= [.0489*( .3 )*(1-.3)] + [ .0884*( .2 )] + [ .148*( .5 )]
=10.19%
F. How is any firm’s stock price (or the value of the firm) related to WACC?
Explain in words.
The capital funding of a company is made up of two components: debt and equity
Lenders and equity holders each expect a certain return on the funds or capital they have
provided. The cost of capital is the expected return to equity owners (or shareholders) and
to debt holders, so WACC tells us the return that both stakeholders - equity owners and
lenders - can expect. WACC, in other words, represents the investor's opportunity cost of
taking on the risk of putting money into a company.
G. As a financial analyst, what could be your suggestion to reduce WACC?
The lower the company’s WACC, the better. More value is created by a lower WACC
because of the resulting increased spread between it and the ROIC. The most effective
ways to reduce the WACC are to: (1) lower the cost of equity or (2) change the capital
structure to include more debt. Also, to calculate the WACC, we consider the average of
the company’s interest rate cost and the investor’s return. The aim of any company is to
reduce the cost and capital returns, and also tries to maximize its interest in an efficient
way. By investing, BHH may increase the interest and decrease the return for the
stockholders. BHH must have a specific way in which it will decrease the WACC. Loans
and preferred stock should be paid off, but, loans must be at a higher rate.
1. Decreasing the cost by subordinating the company’s beta.
2. Decreasing the rate of debt.
3. Depreciating the effect of tax rate.
4. Appreciating the optimal leverage.