Saba Soliman al-Mohawis 201000230 Financial Management Principles, FINA 3311 Fall Semester, 2012

Recently, though, capital costs have been declining, 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, 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 Jerry Price, the financial vice president. Your first task is to estimate BHH’s cost of capital.

provided data firm’s tax rate =30% The current price of BHH’s 12 percent coupon, semiannual payment, bonds with 10 years remaining to maturity is $1,140.00. The current price of the firm’s 10 percent, $100 par value dividend, perpetual preferred stock is $113.10. flotation costs of $2.00 per share on a new issue.  BHH’s common stock is currently selling at $50 per share (D0) was $4.19 expected to grow= 5% beta = 1.30 the yield on T-Bonds= 7% the market return =13%. Target capital structure: 30 percent long term debt 20 percent preferred stock 50 percent common equity.

What sources of capital should be included when you estimate BHH’s weighted average cost of capital (WACC)? Sources of Capital: Internal Source: Retained Earnings External Source: Debt Securities External Source: New Common Stock   Bond (debt), Preferred Share, and Equity (most firms raise capital with a combination of debt, equity, and hybrid securities). 

What is the market interest rate on BHH’s debt and its component cost of debt? Compute the Yield-to- Maturity Using the financial calculator YTM is 4.89% Thus, the annual YTM is 9.77% (4.89% x 2) After tax cost of debt = kd (1-T) After tax cost of debt = 9.77% (1-.30) After tax cost of debt = 6.84% Given:   Interest (PMT) = 1,000 x 12% /2= 60 Current Price (PV) = - 1,140 Maturity Value (FV) = 1,000 Number of compounding period (N) = 10 x 2 = 20 Tax rate which is 30%

BHH does not plan to issue new shares of common stock BHH does not plan to issue new shares of common stock. Using the CAPM approach, what is the BHH’s estimated cost of equity? Cost of Equity using the CAPM approach; Cost of Equity = Krf + (kM- kRF) β Cost of Equity = 7% + (13% -7%) 1.30 Cost of Equity = 14.8%   Given: Risk-free rate Krf (yield on T-Bonds) = 7% Beta coefficient, β =1.30 Market Return = 13%

What is the estimated cost of equity using the constant dividend growth model? Cost of common equity using the dividend growth model is computed as follows;   Cost of Equity = Div0 x (1 + g) + g Price 4.40 + 5% 50 Cost of Equity = 13.8% Given: Dividend in Year 1 = (D0 x 1+g) thus D1 = 4.19 x 1.05 = 4.40 Growth rate = 5% Current price of BHH common stock = $50 per share

Component cost of preferred stock Cost of preferred stock = Dividend Price – Flotation cost Cost of preferred stock = 10/ (113.10 – 2.00) Cost of preferred stock = 9% Given: Price of preferred stock = $113.10 Flotation cost for new issues =$2.00 Preferred stock dividends = 100 x 10% = 10 The component cost of preferred stock is computed as follows;

What is BHH’s WACC? WACC After-tax Cost of Capital Capital Structure Weights Source of Capital 2.052% 6.84% 30% Bonds 1.8% 9.00% 20% Preferred Stock 6.4% 13.80% 50% Common Equity 10.252% 100% Total WACC= (.30 x 6.84%) + (.20 x 9.00%) + (.50 x 13.80%) = 10.252%

How is any firm’s stock price (or the value of the firm) related to WACC? Explain in words. Investments are evaluated using the weighted average cost of capital. If the WACC is high, the Net Present Value of an investment is low. Therefore to maximize the value of the firm and to maximize shareholder’s wealth, BHH must find the appropriate mix of capital structure that yields the lowest WACC to achieve its goal. Also, the weighted average cost of capital is the discount rate used in the computation of stock price of the firm. Lower WACC results to higher stock price; it means the more wealth flow to investors, because of stock price appreciation.

As a financial analyst, what could be your suggestion to reduce WACC? The cheapest cost of capital is : Debt preferred stock. The most expensive source of capital is: common stock. ______________________________ To lower the cost of capital, the capital structure must be changed such that majority of the source must come from Debt rather than Equity. BHH must issue bonds instead of common stocks and preferred stock. BHH must issue more of preferred stock rather than common stock. HOWEVER Too much debt will increase risk and increase WACC. BHH must therefore strike the right balance between debt and equity to obtain the optimal capital structure to maximize shareholder’s wealth.

Thank you!!