Mini Case: 9 – 17
f. What is the cost of equity based on the bond-yield-plus-judgmental-risk-
premium method?
g. What is your final estimate for the cost of equity, rs?
h. What is Jana’s weighted average cost of capital (WACC)?
i. What factors influence a company’s WACC?
Factors The Firm Can Control:
Capital Structure Policy
Dividend Policy
j. Should the company use the overall, or composite, WACC as the hurdle rate for
each of its divisions?
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.
project’s beta. (It’s hard to find such companies.)
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:
Mini Case: 9 – 20
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,
considering risk and alternative investment opportunities. So, the new investment
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
=
r0
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?
Mini Case: 9 – 21
p. What four common mistakes in estimating the WACC should Jana avoid?
the target weights, then use market value rather than book value to obtain the
weights. Use the book value of debt only as a last resort.