Mini Case:
Examine the following book-value balance sheet for Harvard University Products, Inc. The preferred stock currently sells for $15 per share and the common stock for $20 per share. There are one million common shares outstanding.
A) What is the capital structure of the firm based on market values?
| Book value Balance Sheet ($ millions) |
| Assets |
|
Liabilities and Net Worth |
|
| Cash and short term securities |
$1 |
Bonds, coupon - 8'%, paid annually maturity - 10 years, current yield to maturity - 9%) |
10 |
|
|
| Accounts receivable |
3 |
Preferred stock (par value $20 per share) |
2 |
| Inventories |
7 |
Common stock |
10 |
| Plant and equipment |
21 |
Retained earnings |
10 |
| Total |
$32 |
Total |
$32 |
Assume the preferred stock pays a dividend of $2 per share, the beta of the common stock is 1.5, the market risk premium is 7 percent, the risk-free rate is 4 percent, and the firm's tax rate is 40 percent.
B) What is Harvard University's weighted-overage cost of capitol?
Harvard University Products is evaluating a new venture into home computer systems. The internal rate of return on the new venture is estimated at 13.4 percent. WACCs of firms in the personal computer industry tend to average around 14 percent.
C) Should the new project be pursued? What assumptions must be valid to make discounting the cash flows from the proposed venture at Harvard University Products's WACC the correct decision?
D) On the other hand, what assumptions must be valid to making discounting the cash flows from the proposed venture at the average WACC of firms in the personal computer industry the correct decision?