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b. What is the market interest rate on Jana’s debt and what is the component cost of this debt for WACC purposes?
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(5) Jana’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
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% judgmental risk premium.
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A B C D E F G H I
10/28/2015
Situation
COST OF DEBT, rd
N30
PV 1,153.72
PMT 60
B-T rd10%
Tax rate 40%
A-T rd =(1 – Tax rate) x (B-T rd)
A-T rd =60% x10%
Chapter 9. Mini Case
(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.
To help you structure the task, Leigh Jones has asked you to answer the following questions.
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:
a. (1.) What sources of capital should be included when you estimate Jana’s weighted average cost of capital
(WACC)? Answer: See Chapter 9 PowerPoint file.
(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 (D0) was $3.12, and dividends are
(2.) Should the component costs be figured on a before-tax or an after-tax basis? Answer: See Chapter 9
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Flotation costs 5%
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Preferred stock carries a higher risk to investors than debt. Companies are not required to pay preferred dividends
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will be difficulty raising additional funds, and preferred stockholders may gain control of the firm.
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A B C D E F G H I
COST OF PREFERRED STOCK, rps
Pref. Dividend $10.00
Pref. Price $116.95
rps =9.0%
Example:
A-T rps = 9% –9% ×0.12
A-T rps = 7.92%
A-T rd = (1 – Tax rate) × (B-T rd)
A-T rd = 60% ×10%
A-T Risk Premium on Preferred 1.92%
COST OF EQUITY (INTERNAL), rs
PROBLEM
The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it issues
new preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible.
Corporations own most preferred stock, because 70% of preferred dividends are non-taxable to corporations.
Therefore, preferred stock often has a lower before-tax yield than the before-tax yield on debt. But, the after-tax costs
to the issuer are higher on preferred stock than debt. This is consistent with the higher risks of preferred stock.
(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.)
although, firms typically want to pay preferred dividends. Otherwise, they cannot pay common dividends, so there
Assuming the risk-free rate (i.e., the current yield on a long-term Treasury bond) equals 5.6%, the expected market
risk premium is 6%, and the firm’s beta is 1.2, what is the company’s cost of equity from internal funds?
d. (1.) What are the two primary ways companies raise common equity? Answer: See Chapter 9 PowerPoint file.
(2.) Why is there a cost associated with reinvested earnings? Answer: See Chapter 9 PowerPoint file.
(3.) Jana doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Jana’s
estimated cost of equity?
c. (1.) What is the firm’s cost of preferred stock?
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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.
Suppose a firm’s stock trades at $50 and its most recent dividend was $3.12. If the expected constant growth rate is
5.8%, what is the firm’s cost of equity?
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Find g:
growth rate, and what growth rate would you get? Is this consistent with the 5% growth rate given earlier?
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BONUS: APPLICATION OF THE DISCOUNTED CASH FLOW APPROACH WHEN GROWTH IS NOT CONSTANT
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the discounted cash flow valuation procedure for non-constant growth from Chapter 7 to estimate the cost of equity.
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estimated growth rates.
A B C D E F G H I
Risk-free rate 5.6%
Expected market risk premium
6%
Beta 1.2
rs = rRF + (RPM)(bi)
rs = 5.6% +6.0% 1.2
THE DISCOUNTED CASH FLOW APPROACH
e. (1.) What is the estimated cost of equity using the dividend growth approach?
P0 =$50.00
D0 =$3.12
g = 5.8%
D1 =$3.30
2. Retention Growth Model
g =
(1 – Payout rate)
(ROE)
g = 38% 15.00%
g = 5.70%
Step 1:
Create a time line showing the expected future dividend payments. These are based on the current dividend and the
(3.) Could the dividend growth approach be applied if the growth rate was not constant? How?
Suppose the current dividend is $2.16 per share and the current actual price that we observe is $32.00 per share.
Analysts forecast growth of 11% the first year, 10% the second year, 9% the third year, 8% the fourth year, and 7%
thereafter. Estimate the cost of equity.
As we noted earlier, analysts often provide non-constant estimates of future growth. We can use a modification of
e. (2.) Suppose the firm has historically earned 15% on equity (ROE) and retained 35% of earnings, and investors
expect this situation to continue in the future. How could you use this information to estimate the future dividend
The simplest dividend growth approach assumes that growth is expected to remain constant, and in this case: rs =
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A B C D E F G H I
THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH
Year 0 1 2 3 4 5
Growth 11% 10% 9% 8% 7%
Dividend $2.16 $2.40 $2.64 $2.87 $3.10 $3.32
Step 2:
Price at Year 4 = $42.20
Step 3:
Calculated Current Price = $32.00
Step 4:
rs=14.87%
Note: you must begin with a value that is greater than the long-term constant growth
rate.
Using the constant growth formula from Chapter 7 to estimate the price at Year 4: P4 = D5 / (rs – g). Notice that D5 and
g are given in the time line above, but the estimate for rs is shown below.
Calculate the current price of the stock, based on the estimate of rs below. To do this, find the present value of the
price at Year 4, P4, and then find the present value of the dividends from Year 1 through Year 4. Use the cost of
equity, rs, shown below, as the discount rate.
Use Goal Seek to determine the cost of equity, rs, shown below. Click Tools (What-If Analysis), Goal Seek and set the
value of the Calculated Current Price, cell C191, equal to the actual current stock price of $32 by changing the cost of
equity, rs, in cell B199. Note: You must begin with a value in cell B199 that is greater than the long-term growth rate
of 7%, or the constant growth formula will not be valid.
Note that if rs is not equal to 14.87%, then the Calculated Current Price will not be equal to the actual current price of
$32. In other words, 14.87% is the only correct value for rs, given the current stock price, the expected future
dividends, and the long-term constant growth rate of 7%.
f. What is the cost of equity based on the over-own-bond-yield-plus-judgmental-risk-premium method?
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after-tax cost of debt, cost of preferred stock, and cost of common equity.
It is common to use several methods to estimate the cost of equity, and then find the average of these methods.
The weighted average cost of capital (WACC) is calculated using the firm’s target capital structure together with its
A B C D E F G H I
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 dividend growth estimates. This method is used primarily in
utility rate case hearings.
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D0 =$3.12
the issuance of new securities. A company cannot use the entire proceeds of a new security issuance, because it
must use some of the proceeds to pay the flotation costs.
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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: See Chapter 9 PowerPoint file.
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rs = D1÷
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PROBLEM: Flotation Costs and the Cost of Debt
A B C D E F G H I
WACC =
(wd × rd) ×(1 – T) + (ws × rs)
WACC = 1.2% x60% + 14.2%
WACC = 14.9%
14.94%
10.38%
ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTS
g = 5.8%
D1 =$3.30
rs = D1÷P0+ g
rs = $3.30 ÷$50.00 +5.8%
Net proceeds after flotation costs =
$50.00 85%
Net proceeds after flotation costs = $42.50
Net proceeds after flotation costs = $42.50
D1 =$3.30
rs = $3.30 ÷$42.50 +5.8%
Division WACC
m. What are three types of project risk? How is each type of risk used? Answer: See Chapter 9 PowerPoint file.
This indicates that the division’s market risk is greater than the firm’s average division. Typical projects within this
new division would be accepted if their returns are above the divisional WACC.
Company WACC
Notice that this cost of stock is quite different than the cost of stock without flotation costs. To find the cost of
perpetual preferred stock, simply use the procedure above with g = 0. If the preferred stock has a fixed maturity, then
use the same procedure as for debt, except that the preferred dividend is not tax deductible.
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 issue?
flotation costs into the dividend growth approach. What is the estimated cost of newly issued stock, taking into
account the flotation cost?
Flotation costs are the fees charged by investment bankers plus the accounting and legal expenses associated with
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A B C D E F G H I
Maturity payment = $1,000
Pre-tax coupon payment = $100
After-tax coupon payment =
(Coupon
pmt.)
(1 – Tax
rate)
After-tax coupon payment = $100 60%
After-tax coupon payment = $60
Net proceeds after flotation costs = (Par value) (1 – F)
Net proceeds after flotation costs = $1,000 98%
Net proceeds after flotation costs = $980
Number of coupon payments = N = 30
After-tax coupon payment = PMT = 60
Net proceeds after flotation costs = PV = 980
Payment of face value at maturity = FV = 1000
After tax cost of debt = Rate = 6.15% Note: use the Rate function.
Now find the rate that the company pays, based on its net proceeds after flotation costs and its after-tax payments.
p. What four common mistakes in estimating the WACC should Jana avoid?
Answer: See Chapter 9 PowerPoint file.
First, calculate the after-tax coupon payments and the net proceeds after the flotation costs.
Notice that this after-tax cost of debt is only slightly higher than the after-tax cost of debt for which flotation costs are
ignored. Therefore, analysts often ignore the flotation costs of debt.