Case Study: Group Project FINA 3311: Financial Management Principles Case Study: Group Project Ayesha Ibrahim Hadeel Alesa Lulwah Alhazzani Deema Alharbi

Case Study You are a financial analyst in BHH Inc. 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. Assume that you are an assistant to Jerry Price, the financial vice president. Your first task is to estimate BHH’s cost of capital

A) What sources of capital should be included when you estimate BHH’s weighted average cost of capital (WACC)? All capital resources are included when calculating WACC such as : Common stocks Preferred stocks Bonds.

B) What is the market interest rate on BHH’s debt and its component cost of debt? Given Solution 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. PMT = 12% = 60 ( (12% / 2) X 1,000) FV = 1,000 N = 10 X 2 = 20 PV = ـ1,140 1/Y = ? = 4.9 since the interest is tax deductible: 4.9 (1- 0.3) = 3.43

C) BHH does not plan to issue new shares of common stock C) BHH does not plan to issue new shares of common stock. Using the CAPM approach, what is the BHH’s estimated cost of equity? Given Formula ke = krf + (km ـ krf ) where: ke = the required return on security krf = the risk-free rate of interest = the beta of security j km = the return on the market index b BHH’s beta is 1.30; the yield on T-Bonds is 7 percent; the market return is estimated to be 13%. b Ke = 0.07 + 1.30 ( 0.13 ـ 0.07) = 0.15

D) What is the estimated cost of equity using the constant dividend growth model? Formula Given ke = D1 + g D0 where: ke = cost of equity D1= dividend at the end of the period D0= current stock price g = growth rate D1 = D0 ( 1 + g ) BHH’s Its last dividend (D0) was $4.19 and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future D1 = 4.19 (1 + 0.05) = 4.40 Ke = (4.40 / 4.19) + 0.05 = 1.10

WACC = Wd(Kd) (1ـ T) + We(Ke) + Wp(Kp) E) What is BHH’s WACC? Given BHH’s target capital structure is 30 percent long term debt, 20 percent preferred stock, and 50 percent common equity The firm’s tax rate is 30 percent BHH would incur flotation costs of $2.00 per share on a new issue. WACC = Wd(Kd) (1ـ T) + We(Ke) + Wp(Kp) Where: Wd = the weight of debt Kd = cost of debt T = tax rate We= the weight of equity Ke= cost of equity Wp= the weight of preferred stock Kp= cost of preferred stock Formula

WACC = Wd(Kd) (1ـ T) + We(Ke) + Wp(Kp) E) What is BHH’s WACC? 30% 30% 50% 20% WACC = Wd(Kd) (1ـ T) + We(Ke) + Wp(Kp) 4.9 (from B) 1.10 (from D) ? 0.15 (from C)

E) What is BHH’s WACC? Given Kp = Dp Pp ـ F Where: Kp= cost of preferred stock Dp= dividend on preferred stock Pp= Price of preferred stock F= Floatation Given The current price of the firm’s 10 %, $100 par value dividend paid quarterly preferred stock is $113.10 flotation costs of $2.00 per share Dp = 2.5 ( ( 10% / 4 ) X 100) Pp = 113.1 F = 2 Kp = 2.5 / ( 113.1 ـ 2 ) = 0.02

WACC = Wd(Kd) (1ـ T) + We(Ke) + Wp(Kp) E) What is BHH’s WACC? 30% 30% 50% 20% WACC = Wd(Kd) (1ـ T) + We(Ke) + Wp(Kp) 4.9 (from B) 1.10 (from D) 0.02 0.15 (from C) WACC = 0.3 (4.9) (1ـ 0.3) + 0.5 (1.10) + 0.2 (0.02) = 1.03 + 0.55 + 0.004 = 1.58 WACC = 0.3 (4.9) (1ـ 0.3) + 0.5 (0.15) + 0.2 (0.02) = 1.03 + 0.08 + 0.004 = 1.11

F) How is any firm’s stock price (or the value of the firm) related to WACC? Explain in words. As the firm's Weighted Average Cost of Capital (WACC) reaches its minimum level, the maximum stock price occurs. A company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing. The minimum WACC occurs at the same Debt and equity ratio that maximizes the firm value. The stock price is optimized at the maximum firm value. The firm reaches its Maximum value at the Optimal Debt/Equity ratio for this firm.  

G) As a financial analyst, what could be your suggestion to reduce WACC? The Company could lower its WACC, by increase its use of cheaper financing sources. For example, BHH Inc could issue more bonds instead of stocks so, the proportion of debt to equity will increase because the debt is cheaper than the equity so, the company's weighted average cost of capital would decrease. But only to a certain point because too much debt will make the company more risky and will cause the stock component of WACC increase.

Thank you

References: Boehme.R, Corporate Finance, Limits to the Use of Dept Policy. P.4. http://www.rdboehme.com/MBA_CF/Chap_16.pdf