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 40%. The current price of Jana’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. 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. 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. 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. Jana’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

Question 0:

(1) Jana estimates that if it issues new common stock, the flotation cost will be 15%. Jana incorporates the flotation costs into the dividend growth approach. What is the estimated cost of newly issued common stock, taking into account the flotation cost?

(2) Jana issues 30-year debt with a par value of $1,000 and a coupon rate of 10%, paid annually. If flotation costs are 2%, what is the after-tax cost of debt for the new bond issue?

Answer 1

	.(1)
	D0	Last dividend	$3.12
	g	Constant Growth Rate=5.8%=	0.058
	D1=D0*(1+g)	Expected dividend in year 1	$3.30
	P0	Current Price of stock	$50
	R=(D1/P0)+g	Required Return =(3.3/50)+0.058=	0.124019
		Required Return =	12.40%
		Flotation Cost=15%=	0.15
		Cost of Equity =12.4/(1-0.15)=	0.145905
		Estimated Cost of new common stock	14.59%
	.(2)	Par value of Bond	$1,000
		Flotation Cost=1000*2%	$20
	Pv	Net amount	$980
	Pmt	Annual Coupon payment =1000*10%	$100
	Fv	Amount to be paid on maturity	$1,000
	Nper	Number of years	30
	RATE	Before tax cost of debt	10.22%	(using RATE function of excel with Nper=30, Pv=-980,Pmt=100,Fv=1000)
		Excel command:RATE(30,100,-980,1000)
		Tax Rate=40%	0.4
		After Tax Cost of Debt=10.22*(1-0.4)=	0.061296
		After Tax Cost of Debt for the new Bond issue	6.13%