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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:
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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.
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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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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A B C D E F G H I
11/21/2018
COST OF DEBT, rd
N30
PV 1,153.72
PMT 60
FV 1000
rd = 10%
A-T rd =7.5%
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.
The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The after-tax rate is
calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate.
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: 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
(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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Pref. Dividend $10.00
Pref. Price $116.95
Flotation costs 5%
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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.
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premium is 6%, and the firm’s beta is 1.2, what is the company‘s cost of equity from internal funds?
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A B C D E F G H I
COST OF PREFERRED STOCK, rps
rps =9.0000% Note: Round this to 4 decimal places.
A-T rps = rps –rps ×(1 – 0.5) × T
A-T rps = 9.000% –9.000% ×12.500%
A-T rps = 7.8750%
A-T rd = (1 – Tax rate) × (B-T rd)
A-T rd = 75% ×10%
A-T rd = 7.5%
A-T Risk Premium on Preferred 0.375%
COST OF EQUITY (INTERNAL), rs
Risk-free rate 5.6%
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.
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.
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.
(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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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?
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.
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growth rate would you get? Is this consistent with the 5% growth rate given earlier?
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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.
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.
A B C D E F G H I
Expected market risk premium 6%
Beta 1.2
rs = rRF + (RPM)(bi)
rs = 5.6% +6.0% 1.2
rs = 5.6% +7.2%
rs = 12.80%
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
rs = D1÷P0+ g
rs = $3.30 ÷$50.00 +5.80%
rs = 6.60%
rs =12.40%
2. Retention Growth Model
Find g:
Payout rate = 62%
ROE = 15%
g =
(1 – Payout rate)
(ROE)
g = 38% 15.00%
g = 5.70%
BONUS: APPLICATION OF THE DISCOUNTED CASH FLOW APPROACH WHEN GROWTH IS NOT CONSTANT
(3.) Could the dividend growth approach be applied if the growth rate was not constant? How?
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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Step 3:
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.
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THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH
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%.
A B C D E F G H I
Step 2:
Price at Year 4 = $42.20
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.
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 C192, equal to the actual current stock price of $32 by changing the cost of equity, rs, in cell
B200. Note: You must begin with a value in cell B200 that is greater than the long-term growth rate of 7%, or the constant
growth formula will not be valid.
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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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$23.39 million
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A B C D E F G H I
rs = 3.2% +10.0%
rs =13.2%
THE COST OF EQUITY ESTIMATE
Method
Cost of Equity
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
Preferred stock price = $116.95
Number of preferred shares = 200,000
Market value of preferred = $23,390,000
Target capital structure:
wd =30%
wps =10%
g. What is your final estimate for the cost of equity, rs?
rs =
+
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.
Own bond
yield
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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Cost of capital components:
rps =9.0%
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trying to determine the cost of capital for this new division, you discover that specialized firms involved in similar projects have
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A B C D E F G H I
ws =60%
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%
WACC =
(wd × rd) ×(1 – T) + (ws × rs)
WACC = 1.2% x75% + 14.2%
WACC = 15.12%
15.12%
10.83%
p. What four common mistakes in estimating the WACC should Jana avoid?
Answer: See Chapter 9 PowerPoint file.
Target Debt Ratio
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.
Company WACC
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.
l. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are used
to measure a division’s beta? Answer: See Chapter 9 PowerPoint file.
Division WACC