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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 that had been proposed by the marketing department. Assume
that you are an assistant to Leigh Jones, the financial vice-president. Your first task
is to estimate Harry Davis¶ cost of capital. Jones has provided you with the
following data, which she believes may be relevant to your task:

1. The firm's tax rate is 40 percent.

2. The current price of Harry Davis¶ 12 percent coupon, semiannual payment,

noncallable bonds with 15 years remaining to maturity is $1,153.72. Harry
Davis does not use short-term interest-bearing debt on a permanent basis. New
bonds would be privately placed with no flotation cost.

3. The current price of the firm's 10 percent, $100 par value, quarterly dividend,
perpetual preferred stock is $113.10. Harry Davis would incur flotation costs of
$2.00 per share on a new issue.

4. Harry Davis¶ common stock is currently selling at $50 per share. Its last
dividend (d0) was $4.19, and dividends are expected to grow at a constant rate of
5 percent in the foreseeable future. Harry Davis¶ beta is 1.2; the yield on t-bonds
is 7 percent; and the market risk premium is estimated to be 6 percent. For the
bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk
premium.

5. Harry Davis¶ target capital structure is 30 percent long-term debt, 10 percent

preferred stock, and 60 percent common equity.

To structure the task somewhat, Jones has asked you to answer the following
questions.
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Davis¶ weighted average cost of capital (WACC)?

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c. 2. Harry Davis¶ preferred stock is riskier to investors than its debt, yet the
preferred's yield to investors is lower than the yield to maturity on the
debt. Does this suggest that you have made a mistake? (Hint: think
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d. 3. Harry Davis doesn¶t plan to issue new shares of common stock. Using the
CAPM approach, what is Harry Davis¶ estimated cost of equity?
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e. 2. Suppose the firm has historically earned 15 percent on equity (RX ) and
retained 35 percent of earnings, and investors expect this situation to
continue in the future. How could you use this information to estimate
the future dividend growth rate, and what growth rate would you get? Is
this consistent with the 5 percent growth rate given earlier?
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