MINI CASE
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
that has been 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:
1. The firm’s tax rate is 40%.
2. 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.
3. 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.
4. Jana’s common stock is currently selling at $50 per share. Its last dividend (D 0) 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 over-own-bond-yield-plus-judgmental-risk-premium
approach, the firm uses a 3.2% judgmental risk premium.
5. 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 (WACC)?
Answer: 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),
a. 2. Should the component costs be figured on a before-tax or an after-tax basis?
Answer: Stockholders are concerned primarily with those corporate cash flows that are
a. 3. Should the costs be historical (embedded) costs or new (marginal) costs?
Answer: In financial management, the cost of capital is used primarily to make decisions
b. What is the market interest rate on Jana’s debt, and what is the component cost
of this debt for WACC purposes?
Answer: Jana’s 12% bond with 15 years to maturity is currently selling for $1,153.72. Thus,
its yield to maturity is 10%:
1,000
Enter N = 30, PV = -1153.72, PMT = 60, and FV = 1000, and then press the I/YR
Optional Question
Should flotation costs be included in the estimate?
Answer: The actual component cost of new debt will be somewhat higher than 6% because the
Optional Question
Should you use the nominal cost of debt or the effective annual cost?
Answer: Our 10% pre-tax estimate is the nominal cost of debt. Since the firm’s debt has
However, nominal rates are generally used. The reason is that the cost of capital is
c. 1. What is the firm’s cost of preferred stock?
Answer: Since the preferred issue is perpetual, its cost is estimated as follows:
rps =
)F1(P
D
ps
ps
=
)05.0.1(95.116$
)100($1.0
=
10.111$
10$
= 0.090 = 9.0%.
Note (1) that flotation costs for preferred are significant, so they are included here, (2)
c. 2. Jana’s preferred stock is riskier to investors than its debt, yet the preferred’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.)
Answer: Corporate investors own most preferred stock, because 70% of preferred dividends
received by corporations are nontaxable. Therefore, preferred often has a lower
d. 1. What are the two primary ways companies raise common equity?
d. 2. Why is there a cost associated with reinvested earnings?
Answer: Management may either pay out earnings in the form of dividends or else retain
d. 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?
s
r
0
1
P
D
g
P
)g1(D
0
0
058.0
50$
)058.1(12.3$
e. 3. Could the dividend growth approach be applied if the growth rate was not
constant? How?
Answer: Yes, you could use the dividend growth approach using nonconstant growth. You
f. What is the cost of equity based on the
bond-yield-plus-judgmental-risk-premium method?
Answer: rs = Company’s own bond yield + judgmental risk premium.
g. What is your final estimate for the cost of equity, rs?
Answer: The final estimate for the cost of equity would simply be the average of the values
found using the above three methods.
CAPM 12.8%
h. What is Jana’s weighted average cost of capital (WACC)?
= 0.1038 = 10.38%.
i. What factors influence a company’s WACC?
Answer: There are factors that the firm cannot control and those that they can control that
influence WACC.
Factors The Firm Cannot Control:
Factors The Firm Can Control:
j. Should the company use the overall, or composite, WACC as the hurdle rate for
each of its divisions?
Answer: No. The composite WACC reflects the risk of an average project undertaken by the
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?
Answer: The following procedures can be used to determine a division’s risk-adjusted cost of
capital:
(1) Subjective adjustments to the firm’s composite WACC.
l. 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%.
The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of
capital?
Answer:
rs DIV. = rRF + (rM – rRF)bDIV.
WACCDIV. = wdrd(1 – T) + wsrs
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?
Answer: The three types of project risk are:
Stand-Alone Risk
Corporate Risk
Market Risk
Market risk is theoretically best in most situations. However, creditors,
Taking on a project with a high degree of either stand-alone or corporate risk will
n. Explain in words why new common stock that is raised externally has a higher
percentage cost than equity that is raised internally as retained earnings.
Answer: The company is raising money in order to make an investment. The money has a
cost, and this cost is based primarily on the investors’ required rate of return,
If the company raises capital by selling stock, the company doesn’t receive all of
the money that investors contribute. For example, if investors put up $100,000, and if
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?
Answer:
%.6.31 = %85. +
$42.50
03.3$
=
%85. +
0.15) – $50(1
)8(1.0512.3$
=
g +
F) – (1
P
g) + (1
D
=
r
0
0
e
o. 2. Suppose 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?
Answer: Using a financial calculator, N = 30, PV = (1 – 0.02)(1,000) = 980, PMT = –(1 – 0.40)(100) =
-60, FV = -1000. The resulting I/YR is 6.15%, which is the after-tax cost of debt.
p. What four common mistakes in estimating the WACC should Jana avoid?
2. When estimating the risk premium for the CAPM approach, don’t subtract the
current long-term T-bond rate from the historical average return on stocks.
For example, the historical average return on stocks has been about 12.7%. If
3. Don’t use book weights to estimate the weights for the capital structure. Use the
4. Always remember that capital components are sources of funding that come from