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FINA 3311: Financial Management Principles
Instructor: Rashida Sharmin
Section (201)
Project: Case Study
By:
Shouq Al-Hamoudi 200900213
Rasha Bubahait 200901816
Fadheelah Al-Soqair 200900765
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Case study
Questions:
A. What sources of capital should be included when you estimate BHH’s
weighted average cost of capital (WACC)?
The WACC help to make long term capital investment decisions such as, capital
budgeting. However, the types of capital include the WACC are used to pay for
long term assets which is typically long term debt, common stock and preferred
stock if it already used. The sources in the short term consist by two; the first is
short term interest bearing debt such as notes payable. Second, the spontaneous
noninterest bearing-liabilities such as accounts payable. Therefore, when the firms
used acquire fixed assets in the short term interest bearing debt, then the WACC
will include a short term debt component. In the noninterest bearing debt, the cost
of capital is not included because of the funds are netted out when determining
investment needs.
B. What is the market interest rate on BHH’s debt and its component cost of
debt?
1. Market interest rate:
FV= 1,000
PV= 1,140
PMT= 12% of 1,000 = 120/2 = 60
N=10 * 2 = 20
I/Y= 4.89% => 2*4.89= 9.78%.
2. Component cost of debt:
R (1-T) = 9.78 % (1-0.30) = 6.85%.
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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?
Kj= Krf + β (Km – Krf)
Kj= 7% + 1.30 (13% - 7%) = 14.8%
D. What is the estimated cost of equity using the constant dividend growth
model?
Kcs= D1/Pcs+1.
D0=4.19.
G=5%=0.05.
Pcs=50 per share.
D1=D0 (1+g) =4.19 (1+0.05) = 4.40
Kcs=4.40/50+1= 1.09.
E. What is BHH’s WACC?
WACC= (Wd) (Kd) (1-t) + (Wp)(Kp) + (We)(Ke)
KP= 4.19/10= 11.31%
KE= 14.8% [From C]
KD= 9.78% [From B]
WACC= (30%) (9.78%) (1-30%) + (20%) (11.31%) + (50%) (14.8%) = 46.52
F. How is any firm’s stock price (or the value of the firm) related to WACC?
Explain in words.
When the decisions of the capital structure affect the WACC therefore these
decisions will have an impact on the value of the firm. In this case, the capital
structure which maximizes the value of the firm is the capital structure which
minimizes the WACC.
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G. As a financial analyst, what could be your suggestion to reduce WACC?
WACC is not bad if it increases because that means there will be a high return
required. On the other hand lower WACC is better to be reduced because that
means lower cost lower risk. Lower WACC creates more value.
There some
effective ways to reduce WACC which is lowering the cost of equity or changing
on the structure of the capital change to involve more debt.
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