Question

Chapter 9 Mini Case from Financial Management Theory & Practice 16th Edition:

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 proposed by the marketing department. 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:

- The firm’s tax rate is 25%.

- The current price of Jana’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. There are 70,000 bonds. Jana does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

- The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. There are 200,000 outstanding shares. Jana would incur flotation costs equal to 5% of the proceeds on a new issue.

-Jana’s common stock is currently selling at $50 per share. There are 3 million outstanding common shares. 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 own-bond-yield-plus judgmental-risk-premium approach, the firm uses a 3.2% risk premium. To help you structure the task, Leigh Jones has asked you to answer the following questions:

E. What is the estimated cost of equity using the dividend growth approach? Suppose the firm has historically earned 15% on equity (ROE) and has paid out 62% of earnings, and suppose investors expect similar values to obtain 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? Could the dividend growth approach be applied if the growth rate were not constant? How?

Answer 1

E.)

The estimated cost of equity using the dividend growth approach

Cost of equity

= (3.12*(1.058)/50) + 0.058 = 12.40%

Suppose the firm has historically earned 15% on equity (ROE) and has paid out 62% of earnings

The growth rate is the retention ratio times the ROE

Retention ratio = 1-payout ratio

g = (1-payout ratio)*ROE

g = (1-0.62)*0.15

g = 0.057 = 5.70%

Yes, this rate is consistent with the 5.8% growth rate given earlier.

Yes, the dividend growth approach is applied if the growth rate were not constant. This can be done by manually discounting future dividends. If the growth rate is different for different periods, the dividends should be discounted to their PV using appropriate discount rate. If the dividends growth rate is different for a short period and then stabilizes, then the terminal value must be calculate the year from when the dividend growth rate stabilizes and this terminal value must be discounted back to the present value. In such cases, a 2-stage dividend discount model must be applied.