The Jackson company has a target capital structure that calls for 35 percent deb

Question

The Jackson company has a target capital structure that calls for 35 percent debt,10 percent prefered stock, and 55 percent common equity. Its outstanding bonds have a 7 percent coupon(paid semiannully), a current maturity of 20 years, and sell for $815.98. The firm could sell its preferred stock at $96. The prefeered stocks have a par value of$100, and pay an 8 percent annual dividend. The firm's beta is 1.45, the risk-free rate is 3 percent, and the market risk premium is 6 percent. The company is a constant growth firm with a growth rate of 5%. Its common stock currently sells for $30 per share and just paid a dividend of$2.00. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk -premium method to find rs. The firm's marginal tax rate is 40 percent.

a. Calculate the company's cost of debt and cost of preferred stock.

b. Use CAPM, DCF and bond- yield -plus-risk-premium approach to estimate the cost of retained earnings. What is your final estimate of rs?

c. What is your estimate of re (cost of the new common stock) if the flotation cost of 20 percent would be incurred when the company issue new common stocks?

d. Calculate the company's WACC by using cost of retained earnings.

Explanation / Answer

(a) Since company has only one bond with 7% coupon semi-annually and no other bond issued.

Then cost of debt is the coupon payment rate i.e. 7%

Annual Dividend in Preferred Stock= Par Value of Preferred Stock*Coupon Rate = 100*0.08 = $8

Current Market Price = $96

Cost of Preferred Stock = Annual Dividend in Preferred Stock/Current Market Price = 8/96 = 8.33%

(b) CAPM - Capital Asset Pricing Model

E(Rs) = Rf + Beta*(Rm - Rf) = 3% + 1.45*6% = 11.7%

DCF - Discounted Cash Flow

P0 = D1/(r-g) =

r = D1/P0 +g = 2/30 + 0.05 = 11.7%

Face Value = 1,000

Current Price = 815.98

Coupon - 7% Semi-Annually

Bond's YTM = 4.5%

Bond-Yield-Plus-Risk -Premium = Bond's YTM + Risk Premium = 4.5% + 6% = 10.5%

Final rs is 11.7% as per CAPM and DCF method

(c) New re = D1/P0*(1-float rate) +g

re = 2/30*0.8 + 0.05 = 0.13 = 13%

(d)

WACC = 35%*cost of debt*(1-tax rate) + 10%*cost of preferred stock + 55%*cost of common equity

WACC = 0.35*0.07*0.6 + 0.1*0.0833 + 0.55*0.117 = 0.015+ 0.00833 + .064 = 0.0873 = 8.73%

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