Case Study about BHH Inc. Financial Management Principles Section: 201 Case Study about BHH Inc. Done By: Fatima Al-Sughayr 200900199 Latifa Al-Shammari 200900329 Razan Al-Subaie 200900042 Ruqaya Alhaj Ibrahim 200900531

The Case Study During the last few years, BHH Inc. 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. We as an assistant to Jerry Price, the financial vice president. our first task is to estimate BHH’s cost of capital. Price has provided us with the following data, which he believes may be relevant to our task As we are a financial analysts in BHH Inc…..

The Given Data The firm’s tax rate is 30 percent. The current price of BHH’s 12 percent coupon, semiannual payment, bonds with 10 years remaining to maturity is $1,140.00. Bonds have negligible amount of flotation costs. The current price of the firm’s 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. BHH would incur flotation costs of $2.00 per share on a new issue. BHH’s 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. BHH’s beta is 1.30; the yield on T-Bonds is 7 percent; the market return is estimated to be 13%. BHH’s target capital structure is 30 percent long term debt, 20 percent preferred stock, and 50 percent common equity. These are the given data which we will use in solving the next slide’s questions…

To structure the task, Jerry Price has asked us to answer the following questions: What sources of capital should be included when you estimate BHH’s weighted average cost of capital (WACC)? What is the market interest rate on BHH’s debt and its component cost of debt? BHH does not plan to issue new shares of common stock. Using the CAPM approach, what is the BHH’s estimated cost of equity? What is the estimated cost of equity using the constant dividend growth model? What is BHH’s WACC? How is any firm’s stock price (or the value of the firm) related to WACC? Explain in words. As a financial analyst, what could be your suggestion to reduce WACC?

Q1. What sources of capital should be included when you estimate BHH’s weighted average cost of capital (WACC)? The sources of capital that should be included when estimating WACC are all the sources, which are: Common stock Preferred stock Debt Long-term debt Short-term debt, such as notes payable

The answer for interest rate is 4.25 Q2. What is the market interest rate on BHH’s debt and its component cost of debt? PMT= 120/2= 60 N= 10 PV= - 1140 FV= 1000 I/Y=? The answer for interest rate is 4.25

CAPM = Krf + Beta (Km – Krf) Q3. BHH does not plan to issue new shares of common stock. Using the CAPM approach, what is the BHH’s estimated cost of equity? This question we answer it from the givens in part four. Krf = Treasury-bonds = 7% Km = Market Return = 13% Beta = 1.30 CAPM = Krf + Beta (Km – Krf) = 0.07 + 1.30 (0.13 – 0.07) = 0.148 * 100 = 14.8%

Q4. What is the estimated cost of equity using the constant dividend growth model? This question we answer it from the givens in part four. D0 (the last dividend) = $4.19 G (growth rate) = 5% = 0.05 P0 (current price) = $50 We must find first (D1): D1 = D0 (1+g) = 4.19 (1+0.05) D1 =$4.40

Q4. What is the estimated cost of equity using the constant dividend growth model? (Cont.) Then we substitute D1 =$4.40 in the equation : Ke = ($4.40 / $50) + 0.05 = 0.088 + 0.05 = 8.8% + 5% = 13.8%

WACC = [Wb × Kb × (1-t)] + Wp × Kp + We × Ke  Q5. What is BHH’s WACC? This question we answered it from the givens in part five. Wb (capital structure weight for bonds) = 30% = 0.3 Wp (capital structure weight for preferred stock) = 20% = 0.2 We (capital structure weight for common equity) = 50% = 0.5 Ke (from D) = 13.8% = 0.138 T (Tax rate) = 30% = 0.3   WACC = [Wb × Kb × (1-t)] + Wp × Kp + We × Ke

Q5. What is BHH’s WACC? (Cont.) We must find Kp and Kb :   We got the givens from part three: We got the givens from part two:

Q5. What is BHH’s WACC? (Cont.) Now, we substitute Kp and Kb back in the formula: WACC = [Wb × Kb × (1-t)] + Wp × Kp + We × Ke   = [0.3 × 0.0526 × (1 - 0.3)] + (0.2 × 0.09) + (0.5 × 0.138) = 0.011 + 0.018 + 0.069 = 0.098 = WACC = 9.8%

Q6. How is any firm’s stock price (or the value of the firm) related to WACC? Weighted Average Cost of Capital identifies the minimum rate of return to create value for the firm. If the returns are equal to or more than WACC, then investors will continue investing in the firm, but if returns were less, then they would probably quit in order to avoid losses. Having returns that are less than WACC will lead to reduction in the stock price of the firm. The relationship between the firm stock price and WACC helps in evaluating new projects. The firm stock price will go up if the returns were greater than the WACC. This will identify the value of the firm in a market.

 Q7. As a financial analyst, what could be your suggestion to reduce WACC? WACC is calculation of the overall average for the company’s interest rate cost and investors return. The BHH Company has to minimize the return for the shareholders by investing in many other big projects to raise the interest. The company should pay off the loans and preferred stock early. However, paying off the loans should start with the higher rates and than the preferred stock.

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