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 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 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.

Please answer and show your work for the following questions:

1. • (A)What are the two primary ways companies raise common equity?
   • (B)Why is there a cost associated with reinvested earnings?
   • (C)Jana doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Jana’s estimated cost of equity?
2. • (A)What is the estimated cost of equity using the dividend growth approach?
   • (B)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?
   • (C)Could the dividend growth approach be applied if the growth rate were not constant? How?

3. What is the cost of equity based on the own-bond-yield-plus-judgmental-risk-premium method?

Answer 1

Ans a)

The two ways that companies can raise common equity are

· Directly by issuing new shares of common stock

· By retained earnings(by re-investing earnings that are not paid out as dividends.

b) There is a cost for reinvested earnings because

Retained earnings belong to the shareholders since they are effectively owners of the company. If put back into the company, the retained earnings serve as a further investment in the firm on behalf of the shareholders. Earnings can be paid out either as dividends or can be reinvested.

The cost of those retained earnings equals the return shareholders should expect on their investment. It is called an opportunity cost because the shareholders sacrifice an opportunity to invest that money for a return elsewhere and instead allow the firm to build capital. Investors could by other securities and earn a return.

c)By CAPM

Cost of equity Ki=Rf+ β(Rm-Rf)

Ki: Required / expected return on security i/cost of equity

Rf: Risk free rate=5.6%

bi : Beta coefficient of systematic risk of security i=1.2

Market Risk premium Rm-Rf=6%

Km- Required rate of return on the market portfolio

Ki=5.6+1.2*6

=12.8

d)According to dividend growth approach cost of equity=D1/P0 +g

Expected rate of return =Expected dividend yield +Expected growth rate

Given D1=3.12

G=5.8%

P0=$50

So ,cost of equity=(3.12(1.058)/50)+.058 =.1240=12.40 %