Question

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. 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:

•                   ●  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 pre- 
ferred stock is $116.95. There are 200,000 outstanding shares. Jana would incur flota- 
tion 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: 


1. What is your final estimate for the cost of equity, rs? 


Answer 1

Step 1: Calculate Cost of Equity with the Use of Discounted Cash Flow Method

The cost of equity with the use of discounted cash flow method is determined as below:

Cost of Equity (Discounted Cash Flow Method) = Last Dividend*(1+Growth Rate)/Current Selling Price + Growth Rate

Substituting values in the above formula, we get,

Cost of Equity (Discounted Cash Flow Method) = 3.12*(1+5.8%)/50 + 5.8% = 12.40%

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Step 2: Calculate Cost of Equity with the Use of CAPM Method

The cost of equity with the use of CAPM method is calculated as follows:

Cost of Equity (CAPM Method) = Risk Free Rate + Beta*(Market Risk Premium)

Substituting values in the above formula, we get,

Cost of Equity (CAPM Method) = 5.6% + 1.2*(6%) = 12.80%

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Step 3: Calculate Cost of Equity with the Use of Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method

First, we need to calculate the bond yield. The bond yield can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Payment (here, Coupon Payment), PV = Present Value (here, Current Bond Price) and FV = Future Value (here, Face Value of Bonds).

Here, Nper = 15*2 = 30, PMT = 1,000*12%*1/2 = $60, PV = $1,153.72 and FV = $1,000

Using these values in the above function/formula for Rate, we get,

Bond Yield (Pretax) = Rate(30,60,-1153.72,1000)*2 = 10%

Bond Yield (Aftertax) = Bond Yield (Pretax)*(1-Tax Rate) = 10%*(1-25%) = 7.50%

Now, we can calculate cost of equity with the use own-bond-yield-plus- judgmental-risk-premium method as below:

Cost of Equity (Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method) = Bond Yield (Aftertax) + Risk Premium = 7.50% + 3.2% = 10.70%

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Step 4: Calcuate Final Estimate of Cost of Equity

The final estimate of cost of equity is arrived as follows:

Final Estimate of Cost of Equity = [Cost of Equity (Discounted Cash Flow Method) + Cost of Equity (CAPM Method) + Cost of Equity (Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method)]/3 = (12.40% + 12.80% + 10.70%)/3 = 11.97%