During the last few years, Jana Industries has been too constrained by the high

Question

During the last few years, Jana Industries 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 proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Jana’s cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:

• The firm’s tax rate is 40%. • The current price of Jana’s 12% coupon, semiannual payment, noncallable bonds with

15 years remaining to maturity is $1,153.72. Jana does not use short-term interest-bearing

debt on a permanent basis. New bonds would be privately placed with no flotation cost. • The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual

preferred stock is $116.95. Jana would incur flotation costs equal to 5% of the

proceeds on a new issue. • Jana’s common stock is currently selling at $50 per share. Its last dividend D0 was

$3.12, and dividends are expected to grow at a constant rate of 5.8% in the foreseeable future. Jana’s beta is 1.2, the yield on T-bonds is 5.6%, and the market risk premium is estimated to be 6%. For the own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3.2% risk premium.

• Jana’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

To help you structure the task, Leigh Jones has asked you to answer the following questions.

a. (1) What sources of capital should be included when you estimate Jana’s weighted average cost of capital?

(2) Should the component costs be figured on a before-tax or an after-tax basis? (3) Should the costs be historical (embedded) costs or new (marginal) costs?

b. What is the market interest rate on Jana’s debt, and what is the component cost of this debt for WACC purposes?

c. (1) What is the firm’s cost of preferred stock? (2) Jana’s preferred stock is riskier to investors than its debt, yet the preferred

stock’s yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

d. (1) What are the two primary ways companies raise common equity? (2) Why is there a cost associated with reinvested earnings? (3) Jana doesn’t plan to issue new shares of common stock. Using the CAPM

approach, what is Jana’s estimated cost of equity?

e. (1) What is the estimated cost of equity using the dividend growth approach? (2) Suppose the firm has historically earned 15% on equity (ROE) and has paid out 62% of earnings, and suppose investors expect similar values to obtain in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5.8% growth

rate given earlier? (3) Could the dividend growth approach be applied if the growth rate were not

constant? How?

f. What is the cost of equity based on the own-bond-yield-plus-judgmental-risk- premium method?

g. What is your final estimate for the cost of equity, rs?

h. What is Jana’s weighted average cost of capital (WACC)?

i. What factors influence a company’s WACC?

j. Should the company use its overall WACC as the hurdle rate for each of its divisions?

k. What procedures can be used to estimate the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta?

j. Jana is interested in establishing a new division that will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that specialized firms involved in similar projects have, on average, the following characteristics: Their capital structure is 10% debt and 90% common equity; their cost of debt is typically 12%; and they have a beta of 1.7. Given this information, what would your estimate be for the new division’s cost of capital?

m. What are three types of project risk? How can each type of risk be considered when thinking about the new division’s cost of capital?

n. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by retaining earnings.

o. (1) Jana estimates that if it issues new common stock, the flotation cost will be 15%. Jana incorporates the flotation costs into the dividend growth approach. What is the estimated cost of newly issued common stock, taking into account the flotation cost?

(2) Jana issues 30-year debt with a par value of $1,000 and a coupon rate of 10%, paid annually. If flotation costs are 2%, what is the after-tax cost of debt for the new bond issue?

p. What four common mistakes in estimating the WACC should Jana avoid?

Explanation / Answer

As per the rules, I will answer the first 4 sub-parts of this question only.

a. 1. The cost of capital should include equity shares, preference shares and bond

2. The component costs should be estimated after tax.

3. For estimating cost of capital, we use the marginal cost.

b. Market interest of the bonds can be found by computing the YTM of the bonds using excel Rate function as

=RATE(30,60,-1153.72,1000)

where 30 = periods = 15*2 semiannual periods

coupon = 12%*100/2 = $60 per semiannual period

Hence YTM = 5% semiannual

=10% p.a before tax and

Component cost = 10%*(1-0.4) = 6% after tax

c. 1. Cost of preferred stock = Preference dividend/ Price*(1-floatation)

= 10/ 116.95*95%

= 8.12%

(Floatation cost = 5% of the proceeds which means Jana will get only 95% of the price)

2. Corporate investors own most of the preferred stock. This is because 70 percent of preferred dividends received by corporations are nontaxable. Hence preferred stock has a lower before-tax yield than debt issued by the same company. However, the after-tax yield to a corporate investor as also the after-tax cost to the issuer, are higher on preferred stock than on debt.

d. 1. Companies raise equity by new issue and by retaining earnings.

2. Retained earnings have an opportunity cost. If the money is not retained, the same can be paid out to investors who would further invest it to earn income.

3. By CAPM method, cost of equity = Risk free rate + Beta * risk premium

= 5.6% + 1.2*6%

= 12.8%

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