stimate Harley Davidson’s cost of capital. Can you show your work for the solution with the answer underlined in word (not Excel)? Below is the data, which is relevant to the task:
The firm’s tax rate is 40%.
The current price of Harley Davidson’s 12% coupon, semi-annual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. Harley Davidson does not use short-term interest bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harley Davidson would incur flotation costs equal to 5% of the proceeds on a new issue.
Harley Davidson 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% in the foreseeable future. Harley Davidson beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.
Harley Davidson’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.The firm’s tax rate is 40%.
The current price of Harley Davidson’s 12% coupon, semi-annual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. Harley Davidson does not use short-term interest bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harley Davidson would incur flotation costs equal to 5% of the proceeds on a new issue.
Harley Davidson 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% in the foreseeable future. Harley Davidson beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.
To structure the task somewhat, please answer the following questions.
1) What sources of capital should be included when you estimate Harley Davidson’s weighted average cost of capital (WACC)?
2) Should the component costs be figured on a before-tax or an after-tax basis?
3) Should the costs be historical (embedded) costs or new (marginal) costs?
B. What is the market interest rate on Harley Davidson’s debt and its component cost of debt?
C. What is Harley Davidson’s cost of preferred stock?
1) Harley Davidson’s preferred stock is riskier to investors than its debt, yet the preferred’s yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake?
D. What are the two primary ways companies raise common equity?
1) Why is there a cost associated with reinvested earnings?
2) Harley Davidson doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Harley Davidson’s estimated cost of equity?
e. What is the estimated cost of equity using the discounted cash flow (DCF) approach?
1) Suppose the firm has historically earned 15% on equity (ROE) and retained 35% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5% growth rate given earlier?
2) Could the DCF method be applied if the growth rate was not constant? How?
F. What is the cost of equity based on the bond-yield-plus-risk-premium method?
G. What is your final estimate for the cost of equity, rs?
H. What is Harley Davidson’s weighted average cost of capital (WACC)?
I. What factors influence a company’s WACC?
J. Should the company use the composite WACC as the hurdle rate for each of its divisions?
K. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta?
L. Harley Davidson is interested in establishing a new division, which will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that stand-alone firms involved in similar projects have on average the following characteristics:
The capital structure is 10% debt and 90% common equity.
Their cost of debt is typically 12%
The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of capital?
L. Harley Davidson is interested in establishing a new division, which will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that stand-alone firms involved in similar projects have on average the following characteristics:
The capital structure is 10% debt and 90% common equity.
Their cost of debt is typically 12%
The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of capital?
M. What are the three types of project risk? How is each type of risk used?
N. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings.
O. Harley Davidson estimates that if it issues new common stock, the flotation cost will be 15%. Harley Davidson incorporates the flotation costs into the DCF approach.
1) What is the estimated cost of newly issued common stock, taking into account the flotation cost?
1) What is the estimated cost of newly issued common stock, taking into account the flotation cost?
2. Suppose Harley Davidson issues 30-year debt with a par value of $1,000 and a coupon rate of 10%, paid annually. If flotation costs are 2%, what is the after-tax cost of debt for the new bond issue?
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