Financial management problem

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 ;proposed ;by ;the ;marketing ;department. ;Mary ;Simpson ;who ;is ;an ;assistant ;to ;Leigh ;Jones, ;the ;financial ;vice ;president ;is ;asked ;to ;estimate ;Harry ;Davis’s ;cost ;of ;capital. ;Jones ;provides ;Simpson ;with ;the ;following ;data.

1. ;The ;firm’s ;tax ;rate ;is ;40%.

2. ;The ;firm ;has ;10% ;annual ;coupon ;bonds ;with ;15 ;years ;remaining ;to ;maturity. ;The ;current ;price ;of ;the ;bond ;is ;$1, ;096.26. ;The ;bond’s ;yield-to-maturity ;is ;8.82%. ;

3. ;The ;firm’s ;balance ;sheet ;shows ;$100 ;million ;long-term ;debt ;and ;$300 ;million ;common ;equity. ;

Simpson ;estimates ;the ;market ;risk ;premium ;as ;the ;historical ;average ;return ;on ;stocks ;minus ;the ;current ;return ;on ;Treasury ;bonds ;and ;obtains ;a ;15.4% ;of ;the ;cost ;of ;common ;stock ;based ;on ;the ;CAPM.

Simpson ;calculates ;the ;firm’s ;weighted ;average ;cost ;of ;capital ;(WACC) ;as ;follows:

Weight ;of ;long-term ;debt ;is ;.25 ;(=100/400)

Weight ;of ;common ;equity ;is ;.75 ;(=300/400)

WACC ;= ;.25 ;x ;10% ;x ;(1 ;- ;.4) ;+ ;.75 ;x ;15.4% ;= ;13.05%

1. ;Find ;problems ;inherent ;in ;Simpson’s ;WACC ;calculation. ;

2. ;What ;can ;you ;suggest ;to ;solve ;problems ;found ;in ;Question ;1? ;

3. ;Simpson ;used ;the ;CAPM ;to ;estimate ;the ;cost ;of ;common ;stock. ;What ;can ;you ;propose ;to ;get ;the ;best ;estimate ;for ;the ;cost ;of ;common ;stock?

4. ;How ;confident ;can ;you ;be ;with ;the ;WACC ;based ;on ;solutions ;you ;suggested ;through ;the ;evaluative ;process ;in ;terms ;of ;the ;firm’s ;divisions ;and ;projects? ;What ;issues ;should ;be ;considered?