Question

The Jenny Inc. stock sells for $50, and last year’s dividend was $2.10. Jenny also has $100 par preferred stock with a 3.30% dividend, and new preferred stock could be sold at a price of $31.25 per share, with a flotation cost of 4%. It is projected that the common stock dividend will grow at 7% a year. The firm can issue new 10 year at par bonds with coupon rate of 10%, and its marginal tax rate is 35%. The market risk premium is 6%, the risk-free rate is 6.5%, and Jenny  beta is 0.83. Jenny's balance sheet shows $600 million in debt, $100 mil-lion in preferred stock, and $500 million in total common equity. However, its target capital structure is 45% debt, 5% preferred stock, and 50% common equity.

*** Please prepare your Excel Sheets in way that it starts with the inputs used in the model.

Part 1: Calculate the after-tax cost of debt. [2 points]

Part 2: Calculate the cost of preferred stock. [2 points]

Part 3: Calculate the cost of equity, using the dividend growth approach. [2 points]

Part 4: Calculate the cost of equity, using CAPM. [2 points]

Part 5: Comparing your answers to Part 3 and Part 4, what is your final decision for the cost of equity. Please explain. [1 point]

Part 6: List the capital structure weights to be included in the WACC calculation. [2 points]

Part 7: Calculate the company’s WACC? [2 points]

Part 8: If Jenny is evaluating a project with an expected return of 9%, should the project should be accepted or rejected. Please explain. [2 points]

Answer 1

1. As the bonds are issued at par, the coupon rate=yield to maturity=10% which is cost of debt

After tax cost of debt=cost of debt*(1-tax rate)=10%*(1-35%)=6.5%

2. Cost of preferred stock=annual dividend/(price of preferred stock-flotation cost)=3.3/(31.25-(4%*31.25)=11%

3. cost of equity, using the dividend growth approach=(Dividend next year/Share price)+growth rate

Dividend next year=2.1*(1+growth arte)=2.1*(1+7%)=2.247

cost of equity, using the dividend growth approach=(2.247/50)+7%=11.49%

4. cost of equity, using CAPM model=risk free rate+(beta*market risk premium)=6.5%+(0.83*6%)=11.48%

5. By using both the models, the cost of equity is at similar levels.Hence, no problem in using any of the models.

6. We have to use target capital structures: 45% debt, 5% preferred stock, and 50% common equity.

7. WACC=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)+ (weight of preferred stock*cost of preferred stock)=(50%*11.49%)+(45%*6.5%)+(5%*11%)=9.22%

8. We should accepted the project if expected rate of return>WACC or else would be rejected.

Here, expected arte of return of 9% is lower than WACC of 9.22%. Hence, the project has to be rejected.