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Answers and Solutions: 9 - 11
SPREADSHEET PROBLEM
9-18 The detailed solution for the problem is available in the file Ch09 P18 Build a Model
Solution.xlsx at the textbook’s web site.
Mini Case: 9 - 12
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 (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 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.
Mini Case: 9 - 13
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.,
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.
a. 2. Should the component costs be figured on a before-tax or an after-tax basis?
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
website, in whole or in part.
b. What is the market interest rate on Jana’s debt, and what is the component cost
of this debt for WACC purposes?
1,000
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
c. 1. What is the firm's cost of preferred stock?
Answer: Since the preferred issue is perpetual, its cost is estimated as follows:
D
ps
)100($1.0
10$
website, in whole or in part.
d. 2. Why is there a cost associated with reinvested earnings?
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?
0
1
P
D
P
)g1(D
0
0
50$
)058.1(12.3$
e. 2. Suppose the firm has historically earned 15% on equity (ROE) and retained
62% of earnings, and investors expect this situation to continue 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?
e. 3. Could the dividend growth approach be applied if the growth rate was not
constant? How?
