Question

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 35 percent. 2. The current price of Harry Davis’ 8 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,091.96. 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 6 percent, $25 par value, quarterly dividend, perpetual preferred stock is $19.74. Harry Davis would incur flotation costs equal to 5 percent of the proceeds on a new issue. 4. Harry Davis’ common stock is currently selling at $50 per share. Its last dividend (d0) was $2.00, 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 government bonds is 4 percent; and the market risk premium is estimated to be 5 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.

a. 1. What sources of capital should be included when you estimate Harry Davis’ weighted average cost of capital (WACC)?

Answer 1

The WACC is, mainly, used for making long-term capital investment decisions, i.e., for capital budgeting. Hence, WACC should include the types of capital used to pay for long-term assets, and this is generally long-term debt, preferred stock, and common stock or equity stocks.

Short-term sources of capital consist of (1) spontaneous, non-interest-bearing liabilities such as accounts payable and accruals and (2) short-term interest-bearing debt, such as notes payable. If the firm uses short-term interest-bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a short-term debt component. Non-interest-bearing debt is generally not included in the cost of capital calculation because these funds are netted out when determining investment needs, that is, net rather than gross working capital is included in capital expenditures.