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.

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:

a. (1) What sources of capital should be included when you estimate Jana’s weighted average cost of capital?

(2) Should the component costs be figured on a before-tax or an after-tax basis?

(3) Should the costs be historical (embedded) costs or new (marginal) costs?

b. What is the market interest rate on Jana’s debt, and what is the component cost of this debt for WACC purposes?

c. (1) What is the firm’s cost of preferred stock?

(2) Jana’s preferred stock is riskier to investors than its debt, yet the preferred stock’s yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

d. (1) What are the two primary ways companies raise common equity?

(2) Why is there a cost associated with reinvested earnings?

(3) Jana doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Jana’s estimated cost of equity?

e. (1) What is the estimated cost of equity using the dividend growth approach?

(2) 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?

(3) Could the dividend growth approach be applied if the growth rate were not constant? How?

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

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

h. 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?

i. Use Jana’s target weights to calculate the weighted average cost of capital (WACC).

j. What factors influence a company’s WACC?

k. Should the company use its overall WACC as the hurdle rate for each of its divisions?

l. What procedures can be used to estimate the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta?

m. Jana is interested in establishing a new division that will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that specialized firms involved in similar projects have, on average, the following characteristics: Their capital structure is 10% debt and 90% common equity; their cost of debt is typically 12%; and they have a beta of 1.7. Given this information, what would your estimate be for the new division’s cost of capital?

n. What are three types of project risk? How can each type of risk be considered when thinking about the new division’s cost of capital?

o. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings.

p. What four common mistakes in estimating the WACC should Jana avoid?

Answer 1

A. The WACC is used primarily for making long-term capital investment decisions, i.e., for capital budgeting. Thus, the WACC should include the types of capital used to pay for long-term assets, and this is typically long-term debt, preferred stock (if used), and common stock. Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accruals and (2) short term interest-bearing debt, such as notes payable. If the firm uses short-term interest-bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a short-term debt component. Noninterest-bearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs, that is, net rather than gross working capital is included in capital expenditures.

2. Should the component costs be figured on a before-tax or an after-tax basis?

Answer: Stockholders are concerned primarily with those corporate cash flows that are available for their use, namely, those cash flows available to pay dividends or for reinvestment. Since dividends are paid from and reinvestment is made with after-tax dollars, all cash flow and rate of return calculations should be done on an after-tax basis.

3. Should the costs be historical (embedded) costs or new (marginal) costs?
Answer: In financial management, the cost of capital is used primarily to make decisions which involve raising new capital. Thus, the relevant component costs are today's marginal costs rather than historical costs.
b. What is the market interest rate on Harry Davis’s debt, and what is the component cost of this debt for WACC purposes?
Answer: Jana’s 12% bond with 15 years to maturity is currently selling for $1,153.72. Thus, its yield to maturity is 10%:
Enter N = 30, PV = -1153.72, PMT = 60, and FV = 1000, and then press the I/YR button to find rd/2 = 5.0%. Since this is a semiannual rate, multiply by 2 to find the annual rate, rd = 10%, the pre-tax cost of debt.
Since interest is tax deductible, Uncle Sam, in effect, pays part of the cost, and Harry Davis’s relevant component cost of debt is the after-tax cost:
rd(1 - T) = 10.0%(1 - 0.25) = 10.0%(0.75) = 7.5%.