Financial Management Principles
Section: 201
Case Study about BHH Inc.
Done By:
Fatima Al-Sughaiyer
200900199
Latifa Al-Shammari
200900329
Razan Al-Subaie
200900042
Ruqaya Alhaj Ibrahim
200900531
The Case Study
 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.
 We as an assistant to Jerry Price, the financial vice president. our first task is to
estimate BHH’s cost of capital.
 Price has provided us with the following data, which he believes may be relevant
to our task
The Given Data
1. The firm’s tax rate is 30 percent.
1. 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.
1. 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.
1. 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%.
1. BHH’s target capital structure is 30 percent long term debt, 20 percent preferred stock,
and 50 percent common equity.
To structure the task, Jerry Price has asked us to
answer the following questions:
1.
What sources of capital should be included when you estimate BHH’s weighted
average cost of capital (WACC)?
2.
What is the market interest rate on BHH’s debt and its component cost of debt?
3.
BHH does not plan to issue new shares of common stock. Using the CAPM
approach, what is the BHH’s estimated cost of equity?
4.
What is the estimated cost of equity using the constant dividend growth model?
5.
What is BHH’s WACC?
6.
How is any firm’s stock price (or the value of the firm) related to WACC?
Explain in words.
7.
As a financial analyst, what could be your suggestion to reduce WACC?
Q1. What sources of capital should be included when you
estimate BHH’s weighted average cost of capital (WACC)?
The sources of capital that should be included when estimating
WACC are all the sources, which are:
Common stock
Preferred stock
Debt
• Long-term debt
• Short-term debt, such as notes payable
Q2. What is the market interest rate on BHH’s debt
and its component cost of debt?
PMT= 120/2 = 60
N= 10*2 = 20
PV= (-1140)
FV= 1000
I/Y=?
The answer for interest rate is 4.89%
Q3. BHH does not plan to issue new shares of common
stock. Using the CAPM approach, what is the BHH’s
estimated cost of equity?
This question we answer it from the givens in part four.
Krf (Treasury-bonds)= 7%
Km (Market Return)= 13%
Beta = 1.30
CAPM = Krf + Beta (Km – Krf)
= 0.07 + 1.30 (0.13 – 0.07)
= 0.148 * 100
= 14.8%
Q4. What is the estimated cost of equity using the constant
dividend growth model?
This question we answer it from the givens in part four.
D0 (the last dividend) = $4.19
G (growth rate) = 5% = 0.05
P0 (current price) = $50
We must find first (D1):
D1 = D0 (1+g)
= 4.19 (1+0.05)
D1 =$4.40
Q4. What is the estimated cost of equity using the constant
dividend growth model? (Cont.)
Then we substitute D1 =$4.40 in the equation :
Ke = ($4.40 / $50) + 0.05
= 0.088 + 0.05
= 8.8% + 5%
= 13.8%
Q5. What is BHH’s WACC?
This question we answered it from the givens in part five.
Wb (capital structure weight for bonds) = 30% = 0.3
Wp (capital structure weight for preferred stock) = 20% = 0.2
We (capital structure weight for common equity) = 50% = 0.5
Ke (from D) = 13.8% = 0.138
T (Tax rate) = 30% = 0.3
WACC = [Wb × Kb × (1-t)] + Wp × Kp + We × Ke
(Weighted Average Cost of Capital)
Q5. What is BHH’s WACC? (Cont.)
We must find Kp and Kb :
1. We got the givens from part three:
Q5. What is BHH’s WACC? (Cont.)
We must find Kp and Kb :
2. We got the givens from part two:
= 4.89% (from the solution in part B)
Q5. What is BHH’s WACC? (Cont.)
Now, we substitute Kp and Kb back in the formula:
WACC = [Wb × Kb × (1-t)] + Wp × Kp + We × Ke
= [0.3 × 0.0489 × (1 - 0.3)] + (0.2 × 0.0225) + (0.5 × 0.138)
= 0.010269 + 0.0045 + 0.069
= 0.0837
WACC = 8.37%
Q6. How is any firm’s stock price (or the value of
the firm) related to WACC?
 Weighted Average Cost of Capital identifies the minimum rate
of return to create value for the firm.
 The relationship between the value of the firm and Weighted
Average Cost of Capital is opposite, which means that if the
WACC is increasing then the firm’s value will decrease and
vice versa.
 If the returns are equal to or more than WACC, then investors
will continue investing in the firm, but if returns were less,
then they would probably quit in order to avoid losses.
Q6. How is any firm’s stock price (or the value of
the firm) related to WACC?
 Having returns that are less than WACC will lead to
reduction in the stock price of the firm.
 The relationship between the firm stock price and WACC
helps in evaluating new projects.
 The firm stock price will go up if the returns were greater
than the WACC. This will identify the value of the firm in a
market.
Q7. As a financial analyst, what could be your
suggestion to reduce WACC?
 WACC is calculation of the overall average for the company’s
interest rate cost and investors return.
 The BHH Company has to minimize the return for the
shareholders by investing in many other big projects to raise
the interest.
 The company should pay off the loans and preferred stock
early. However, paying off the loans should start with the
higher rates and than the preferred stock.
Thank You