Case Analysis

Dunk Technologies is considering a major expansion program that has been proposed by the
company’s information technology group. Before proceeding with the expansion, the company
must estimate its cost of capital. Suppose you are an assistant to Ramil Gudani, the financial
vice president. Your first task is to estimate Dunk’s cost of capital. Gudani has provided you
with the following data, which he believes may be relevant to your task.

1. The firm’s tax rate is 40%.

2. The current price of Dunk’s 12% coupon, semiannual payment, noncallable bonds with
15 years remaining to maturity is P1,153.72. Dunk does not use short-term interest-
bearing debt on a permanent basis. New bounds would be privately placed with no
flotation cost.
3. The current price of the firm’s 10%, P100.00 par value, quarterly dividend, perpetual
preferred stock is P111.20.
4. Dunk’s common stock is currently selling for P50.0 per share. Its last year’s dividend was
P4.19 and dividends are expected to grow at a constant annual rate of 5% in the
forseeable future. Dunk’s beta is 1.2, the yield on T’bonds is 7%, market risk premium
rate is at 6%.
5. Dunk’s target capital structure is 30% debt, 10% preferred stock, and 60% common
equity.

Questions needed to be answered:

a. Fundamentals
1. What sources of capital should be included when you estimate Dunk’s WACC?
2. Should the component cost be figured on a before-tax basis or after-tax basis?
3. Should the cost be historical cost or new (marginal) cost?
b. What is the market interest rate on Dunk’s debt and its component of cost of debt?
c. Preferred stock
1. What is the firm’s cost of preferred stock?
2. Dunk’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 mean that you
made a mistake?
d. Common equity
1. Why is there cost associated with retained earnings?
2. What is Dunk’s cost of common equity using the CAPM approach?
e. What is the cost of common equity using the DCF approach?
f. What is your final estimate on the cost of common equity?
g. Explain in words why common stock has a higher cost than cost of equity.
h. If Dunk estimates its cost of common stock to have a 15% flotation cost, using the DCF
approach what will be the cost of new issuances of common stock?
i. What is Dunk’s weighted average cost of capital (WACC)?
j. What factors influence Dunk’s WACC?
k. Should the company use composite WACC as hurdle rate for each of its project? Explain.