Harry Davis Case Study

1) Sources of capital to be included when estimating Harry Davis’s WACC:
The WACC is primarily used for making long-term investment decisions that is capital budgeting. The WACC should include the types of capital used to pay for long-term assets like as long-term debt, preferred stock and common stock. Short-term capital consists of account payable, accruals, short-term debts and note payable. WACC should include short-term debt component if the firm is using short-term debt to acquire fixed assets rather than just to finance working capital needs. Non-interest bearing debt is not included in cost of capital estimate as theses funds are netted out when determining investment needs which is net rather than gross working capital is included

(1) Primary ways companies raise common equity: A company can raise common equity in following two ways:
i. By retaining earnings and ii. By issuing new common stock.
d. (2) Cost associated with reinvested earnings or not: The companies may either pay out the earnings in the form of dividends or else retain earnings for reinvestment in business. If part of the earnings is retained, opportunity cost is incurred, stockholders may had received those earnings as dividends and then invested that money in stocks, bonds, real estate and others.
d. (3) Harry Davis’ estimated cost of equity (rs):
We have, rRF = risk-free rate RPM = market risk premium b = beta coefficient

rs = rRF + (RPM)bi

e. (1) Estimated cost of equity using discounted cash flow (DCF) approach: We have, = =

= = 13.8%.
e. (2) Another method for estimating growth rate: Another method for estimating the growth rate is to use the retention growth model: g = (1 - Payout Ratio) ROE
In
This is consistent with the 5% rate given earlier.
e. (3) DCF method could be applied if the growth rate were not

g. Final estimate for the cost of equity: The final estimate for the cost of equity would be the average of the values found using the above three methods:
CAPM 14.2%
DCF 13.8
BOND YIELD + R.P. 14.0
AVERAGE 14.0%

h. Harry Davis’ Weighted Average Cost of Capital (WACC): WACC= wdrd(1 - T) + wpsrps + wce(rs)
= 0.3(0.10)(0.6) + 0.1(0.09) + 0.6(0.14)
= 0.111 = 11.1%.

i. Factors influencing Harry Davis’ composite WACC: There are the internal factors which company can control and the external factor, which is out of company’s control:

External Factors:
Level of Interest rates in market
Tax rates

Internal factors:
Dividend policy
Investment policy
Capital structure policy

j. Use of composite WACC as the hurdle rate for each of its projects: No, the company should not use the overall or composite WACC as the hurdle rate for each of its divisions as the composite WACC reflects the risk of an average project undertaken by the company. Therefore, the WACC only represents the hurdle rate for a typical project with average risk. Different project have different level of risk so the project’s WACC should be