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 (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:

Question:

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?

Answer 1

(a) DEBT

No. of outstanding bonds	70000
Current bond price ($)	1153.72
Market Value of Debt ($)	$80,760,400

Par Value ($)	1000
Coupon rate	12%
Time to maturity	15
Bond price	1153.72
YTM or Kd	10.00%

After-tax cost of debt = Kd*(1-t) = 10%*(1-25%) = 7.50%

PREFERRED STOCK

Market value of preferred stocks = No. of preferred stocks*current price of each preferred stock = 200,000*116.95 = $23,390,000

Cost of preferred stock (Ks) = D1/[P*(1−F)] + g

Ks = 10/[116.95*(1-5%) = 9%

COMMON STOCK

Market value of common stocks = No. of common stocks*current price of each common stock = 3,000,000*$50 = $150,000,000

The estimated cost of equity can be calculated using the following three approaches:

1. Using the dividend growth approach:

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

2. CAPM model approach:

CAPM: Ke = Rf + β*(Rm - Rf) = 5.6% + 1.2*6% = 12.80%

3. Own-bond-yield-plus judgmental-risk-premium approach:

Ke = 10% + 3.2% = 13.20%

We will use the average of the three values as our cost of equity (Ke) = 12.80%

CAPITAL STRUCTURE

Current Capital structure:

Market value of debt = $80,760,400

Market value of preferred equity = $23,390,000

Market value of common equity = $150,000,000

% debt = 31.78% [as against target of 30%]

% preferred equity = 9.20% [as against target of 10%]

% common equity = 59.02% [as against target of 60%]

WACC = % debt*Kd*(1-t) + % preferred equity*Ks + % common equity*Ke = 10.77%