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(2.) Should the component costs be figured on a before-tax or an after-tax basis? Answer: See Chapter 9 PowerPoint file.
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A B C D E F G H I
11/21/2018
Situation
COST OF DEBT, rd
N30
PV 1,153.72
PMT 60
FV 1000
rd = 10%
Chapter 09. Mini Case
(1) The firm’s tax rate is 25%.
(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.
b. What is the market interest rate on Jana’s debt and what is the component cost of this debt for WACC purposes?
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.
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(5) Jana’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
incur flotation costs equal to 5% of the proceeds on a new issue.
premium approach, the firm uses a 3.2% judgmental risk premium.
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A B C D E F G H I
COST OF PREFERRED STOCK, rps
Pref. Dividend $10.00
Example:
A–T rd = (1 – Tax rate) ×(B-T rd)
A–T rd = 75% ×10%
COST OF EQUITY (INTERNAL), rs
The CAPM Approach
PROBLEM
c. (1.) What is the firm’s cost of preferred stock?
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.
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?
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 50% 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.)
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Pref. Price $116.95
Flotation costs 5%
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(3.) Could the dividend growth approach be applied if the growth rate was not constant? How?
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Step 1:
Create a time line showing the expected future dividend payments. These are based on the current dividend and the estimated
growth rates.
cost of equity.
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A B C D E F G H I
Risk-free rate 5.6%
THE DISCOUNTED CASH FLOW APPROACH
e. (1.) What is the estimated cost of equity using the dividend growth approach?
P0 =$50.00
2. Retention Growth Model
Find g:
Payout rate = 62%
BONUS: APPLICATION OF THE DISCOUNTED CASH FLOW APPROACH WHEN GROWTH IS NOT CONSTANT
Year 0 1 2 3 4 5
Growth 11% 10% 9% 8% 7%
The simplest dividend growth approach assumes that growth is expected to remain constant, and in this case: rs = D1/P0 + g.
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 growth rate, and what
growth rate would you get? Is this consistent with the 5% growth rate given earlier?
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?
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.
As we noted earlier, analysts often provide non-constant estimates of future growth. We can use a modification of the
discounted cash flow valuation procedure for non-constant growth from Chapter 7 to estimate the cost of equity.
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Expected market risk premium 6%
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A B C D E F G H I
Dividend $2.16 $2.40 $2.64 $2.87 $3.10 $3.32
Step 2:
Price at Year 4 = $42.20
THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH
f. What is the cost of equity based on the over-own-bond-yield-plus-judgmental-risk-premium method?
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.
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Step 3:
Step 4:
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%.
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.
growth formula will not be valid.
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$23.39 million
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A B C D E F G H I
THE COST OF EQUITY ESTIMATE
THE WEIGHTED AVERAGE COST OF CAPITAL
Current market value capital structure:
Bond price = $1,153.72
Number of bonds = 70,000
Market value of bonds = $80,760,400
$80.76 million
Target capital structure:
g. What is your final estimate for the cost of equity, rs?
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.
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.
It is common to use several methods to estimate the cost of equity, and then find the average of these methods.
h. Jana’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity. How does this compare
with the current market value capital structure? What is Jana’s weighted average cost of capital (WACC)?
i. Use Jana’s target weights to calculated the weighted average cost of capital (WACC).
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to measure a division’s beta? Answer: See Chapter 9 PowerPoint file.
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.
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internally as retained earnings. Answer: See Chapter 9 PowerPoint file.
A B C D E F G H I
Cost of capital components:
T = 25%
Target cost of capital:
WACC = 10.83%
Risk-free rate 5.6%
Market risk premium 6.0%
rs = 15.8%
Beta 1.7
10%
rd12%
Tax Rate 25%
Target Debt Ratio
n. 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.
Given this information, what would your estimate be for the new division’s cost of capital?
j. What factors influence a company’s WACC? Answer: See Chapter 9 PowerPoint file.
k. Should the company use the overall, or composite, WACC as the hurdle rate for each of its division’s? Answer: See Chapter
9 PowerPoint file.