FINANCIAL MANAGEMENT PRINCIPLES
GROUP PROJECT
AMANI ALAHMADI
201000347
N O O R A L S H W A I K H AT 2 0 0 7 0 0 0 5 3
H A N E E N A L FA R W A N
200600715
GUFR A N A L- BAQA L
200600631
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.
Price has provided you with the following data, which he believes may be relevant to your task:

1. The firm’s tax rate is 30 percent.

2. 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.

3. 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.

4. 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%.
5. BHH’s target capital structure is 30 percent long term debt, 20 percent preferred stock, and 50 percent common
equity.

Jerry Price has asked you …?
 What sources of capital should be included when you
estimate BHH’s weighted average cost of capital
(WACC)?
answer :
All capital sources :
-common stock
-preferred stock
-bonds
What is the market interest rate on BHH’s debt
and its component cost of debt?
 By using task #1 ,2
1- The firm’s tax rate is 30 percent.
2- 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.
Given:
PV= -$1,140
FV=$1,000
PMT = 12%/ 2 because semi-annual = 6% = .06
N= 10*2 = 20 because semi-annual
YTM= ?
 YTM= 4.89 ~ 4. 9 %
After-tax cost of Debt = Yield (1-tax rate)
= 4.9 % ( 1- 30%)
= 4.9% * 0.7
= 3.43%
BHH does not plan to issue new shares of common stock. Using the CAPM
approach, what is the BHH’s estimated cost of equity?
 By using task 4 “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%.”
 Given :
Rf= 7%
B = 1.3
Km = 13%
CAMP : kj = krf + j (km - krf )
Kj = 7%+ 1.30 (13%-7%)
Cost of equity estimated = 14.8%
where:
kj = the required return on security = ?
krf = the risk-free rate of interest= 7%
B = the beta of security = 1.3
km = the return on the market index = 13%

What is the estimated cost of equity using the constant dividend growth
model?



By using task 4 “BHH’s common stock is currently selling at $50 per share. Its last dividend (D 0) 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%.”
Given :
D0 = 4.19 $
g = 5%
P0 = 50
The cost of equity could be calculated using the constant dividend growth model using the following
formula:
Ke = (D1 / P0 +g )
before calculate the Cost of common equity in the form of retained earnings we should find D1
 D1 = D0 ( 1+g)
= 4.19 ( 1+5%)
Ke = Cost of common equity in the form
= 4.40 $
of retained earnings
So :
Ke = (D1 / P0 +g )
D1 = Dividend at the end of the first year
= 4.40 / 50 +5%
P0 = Price of stock today
= 4.40 / 50.05
= 0.0879
g = Constant growth rate in dividends
 Cost of common equity = 8.79 %
What is BHH’s WACC?

3- 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.
5- BHH’s target capital structure is 30 percent long term debt, 20 percent preferred stock, and 50 percent
common equity.

WACC is calculated using the following formula:
WACC= Wd(Kd)(1-t)+(Wp)(Kp) +(We)(Ke)

Where,
Wd= The proportion of the financing taken on by debt = 30%
The Wp= The proportion of the financing taken provided by preferred stock = 20%
The We= The proportion of the financing provided by common equity = 50%
Kd= YTM * ( 1- tax rate) = 4.9%* (1-30%) = 3.43%
The Kp= D1 / (P0 – F) +g = 4.40 / ( 50-2) +5% = 14.16%
The Ke= 14.8% from (c )
 Therefore:
WACC = (30%) ( 3.43%) (1-30%) + (20%)(14.16%) + (50%)( 14.8%)
= 0.1095
WACC=10.95%
How is any firm’s stock price (or the value of the
firm) related to WACC? Explain in words
 A firm’s value is related to the WACC of the firm because WACC, by definition, is the
minimum rate of return required to create value for a specific firm. Because the WACC
is the overall required return on the firm as a whole, it is often used as the discount rate
for the valuation of cash flows with risk that is similar to that of the overall firm.
Therefore, to value a firm’s cash flows, whether it was for acquisition or merger
purposes, managers often used the WACC as the discount rate. WACC is related to the
value of the firm because the higher the WACC, the lower the value of the firm and the
lower the WACC, the higher the value of the firm.
As a financial analyst, what could be your suggestion to
reduce WACC?
 One way to decrease WACC is to use more debt than equity because
debt is tax deductible. However it is important to note that too much
debt makes a company more risky and will cause the stock component
of WACC to increase to compensate for the high risk.
 Another option for a financial analyst for reducing WACC is issuing more preferred stock
than common stock because preferred stock is less expensive than common stock. Issuing
preferred stock normally is less expensive than issuing common equity, because common
shareholders are the last in line for company earnings, having the ultimate responsibility for
a company's failure and thus requiring higher rate of return. But using the less expensive
preferred stock instead of common equity is not always an easy choice, because a company
would then be obligated to pay preferred dividends. Even though a company can suspend the
dividends when necessary, it must promise to make that up later. If a company decides to
issue more preferred stock than common equity, the issuance can potentially lower the
company's WACC at the time. Therefore, the immediate benefit of lowering WACC from
issuing preferred stock may disappear over time, and WACC may go up gradually.
 Another way a financial analyst can decrease WACC is
lowering the cost of equity by lowering the beta of the
company by using risk management techniques. This
method is often more difficult to implement than the
previous method and usually takes a longer, but
reducing the risk of the firm and thus the firm’s stock,
could potentially decrease WACC.