Home Products Inc. (HPI) is a leading manufacturer of prescription and ethical drugs, specially food and candies; and proprietary drugs. Important product name includes Advil, Anacin, Dimetapp, Norplant and Robitussin. Total revenue in last fiscal year were in excess of $9 billion. The company has a capital structure 34 percent long-term debt, 13 percent preferred stock, 53 percent common stock. The CEO of HPI is concern about the weighted average cost of capital (WACC) of the firm to compare it with the return on investments. He has asked the Finance manager to give an estimation of WACC of the company.
The finance manager collects the details information from the finance department to reply the investigation of the CEO. The corporate bond has $1,000 par value with 10% coupon interest rate. Annual interest payments are made on this 10-year bond. The current market price of the bond is $955. HPI has to pay corporate tax rate that is 40%. The corporation has 11% (annual dividend) preferred stock at its $100 per value. The cost of issuing and selling preferred stock is $5 per share. The firm’s common stock is currently selling for $80 per share. The firm expects to pay cash dividends $6 per share next year. The firm’s dividend growth rate is 6%.
Required:
i. What is the cost of capital? What role does the cost of capital play in a firm like HPI’s long-term investment decisions? What does the firm’s capital structure represent? 2+5+3=10 Marks
2. Consider yourself as Finance manager of HPI. Now help the CEO to know the WACC. You must calculate separate cost of long-term debt, preferred stock, and common stock before calculating the WACC. You also need to add relevant comment based on your calculation. 20 Marks
