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

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Mini case chapter 9 – Juan N

Accouting (Bethune-Cookman University)

Studocu is not sponsored or endorsed by any college or university

Mini case chapter 9 – Juan N

Accouting (Bethune-Cookman University)

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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

(4.19), and dividends are expected to grow at a constant rate of 5.8% (5) in the foreseeable

future. Jana’s beta is 1.2, the yield on T-bonds is 5.6% (7), 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% (4) 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?

The WACC is used primarily for making long-term capital investment decisions, i.e., for

capital budgeting. Thus, the WACC should include the types of capital used to pay for long-

term assets, and this is typically long-term debt, preferred stock (if used), and common

stock. Short-term sources of capital consist of (1) spontaneous, noninterest-bearing

liabilities such as accounts payable and accruals and (2) short-term interest-bearing debt,

such as notes payable. If the firm uses short-term interest-bearing debt to acquire fixed

assets rather than just to finance working capital needs, then the WACC should include a

short-term debt component. Noninterest-bearing debt is generally not included in the cost

of capital estimate because these funds are netted out when determining investment

needs, that is, net rather than gross working capital is included in capital expenditures.

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2. Should the component costs be figured on a before-tax or an after-tax basis?

Stockholders are concerned primarily with those corporate cash flows that are available for

their use, namely, those cash flows available to pay dividends or for reinvestment. Since

dividends are paid from and reinvestment is made with after-tax dollars, all cash flow and

rate of return calculations should be done on an after-tax basis.

3. Should the costs be historical (embedded) costs or new (marginal) costs?

In financial management, the cost of capital is used primarily to make decisions which

involve raising new capital. Thus, the relevant component costs are today's marginal costs

rather than historical costs.

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

debt for WACC purposes?

Jana’s 12 percent bond with 15 years to maturity is currently selling for $1,153.72. Thus,

its yield to maturity is 10 percent:

c. 1. What is the firm’s cost of preferred stock?

The cost of preferred stock is simply the preferred dividend divided by the price the

company will receive if it issues new preferred stock.

Since the preferred issue is perpetual, its cost is estimated as follows:

Flotation costs for preferred are significant, so they are included here.

Since preferred dividends are not deductible to the issuer, there is no need for a tax

adjustment.

We could have estimated the effective annual cost of the preferred, but as in the case of

debt, the nominal cost is generally used.

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.)

Preferred stock carries a higher risk to investors than debt. Companies are not

required to pay preferred dividends although, firms typically want to pay preferred

dividends. Otherwise, they cannot pay common dividends, so there will be difficulty

raising additional funds, and preferred stockholders may gain control of the firm.

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Corporate investors own most preferred stock, because 70 percent of preferred

dividends received by corporations are nontaxable. Therefore, preferred often has a

lower before-tax yield than the before-tax yield on debt issued by the same company.

Note, though, that the after-tax yield to a corporate investor, and the after-tax cost to

the issuer, are higher on preferred stock than on debt.

d. 1. What are the two primary ways companies raise common equity?

A firm can raise common equity in two ways: (1) by retaining earnings and (2) by issuing

new common stock.

2. Why is there a cost associated with reinvested earnings?

Management may either pay out earnings in the form of dividends or else retain earnings

for reinvestment in the business. If part of the earnings is retained, an opportunity cost is

incurred: stockholders could have received those earnings as dividends and then invested

that money in stocks, bonds, real estate, and so on.

3. Jana doesn’t plan to issue new shares of common stock. Using the CAPM approach,

what is Jana’s estimated cost of equity?

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e. 1. What is the estimated cost of equity using the dividend growth approach?

The simplest DCF model assumes that growth is expected to remain constant, and in this

case:

The next expected dividend is easy to estimate, and the stock price can be determined

readily. However, it is not easy to determine the marginal investor's expected future

growth rate. Three approaches are commonly used: (1) historical growth rates, (2)

retention growth model, and (3) analysts' forecasts.

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?

Another method for estimating the growth rate is to use the retention growth model:

This is consistent with the 5.8% 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?

THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH

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This approach consists of adding a judgmental risk premium to the yield on the firm's own

long-term debt. It is logical that a firm with risky, low-rated debt would also have risky,

high-cost equity. Historically, we have observed that the risk premium for equity is in the

range of 3 to 5 percentage points. This method provides a ballpark estimate, and it is

generally used as a check on the CAPM and DCF estimates. This method is used primarily

in utility rate case hearings.

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

THE COST OF EQUITY ESTIMATE

It is common to use several methods to estimate the cost of equity, and then find the

average of these methods.

Method Cost of equity

CAPM

Constant grow DCF

Bond-yield-plus-judgmental-risk-premium

Average

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

THE WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is calculated using the firm's target capital

structure together with its after-tax cost of debt, cost of preferred stock, and cost of

common equity.

i. What factors influence a company’s WACC?

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