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lOMoAR cPSD| 3013804

Mini case chapter 9 - Juan N
Accouting (Bethune-Cookman University)

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During the last few years, Jana Industries has been too constrained by the high cost of capital to
make many capital investments
...
Assume that you are an assistant to Leigh Jones, the financial vice president
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Jones has provided you with the following data, which she
believes may be relevant to your task:
●

The firm’s tax rate is 40%
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72
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New bonds would be privately placed with no flotation cost
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95
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●

Jana’s common stock is currently selling at $50 per share
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12
(4
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8% (5) in the foreseeable
future
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2, the yield on T-bonds is 5
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For the own-bond-yield-plus-judgmental-risk-premium approach, the
firm uses a 3
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●

Jana’s target capital structure is 30% long-term debt, 10% preferred stock, and 60%
common equity
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a
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What sources of capital should be included when you estimate Jana’s weighted average
cost of capital?
The WACC is used primarily for making long-term capital investment decisions, i
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, for
capital budgeting
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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
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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
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Should the component costs be figured on a before-tax or an after-tax basis?
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
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3
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Thus, the relevant component costs are today's marginal costs
rather than historical costs
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What is the market interest rate on Jana’s debt, and what is the component cost of this
debt for WACC purposes?
Jana’s 12 percent bond with 15 years to maturity is currently selling for $1,153
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Thus,
its yield to maturity is 10 percent:

c
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What is the firm’s cost of preferred stock?
The cost of preferred stock is simply the preferred dividend divided by the price the
company will receive if it issues new preferred stock
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1($ 100)
=

$ 1 16
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1($ 100)
=

$ 116
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05)

=

$ 10
$ 111
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09=9 %

Flotation costs for preferred are significant, so they are included here
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We could have estimated the effective annual cost of the preferred, but as in the case of
debt, the nominal cost is generally used
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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
...
)
Preferred stock carries a higher risk to investors than debt
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Otherwise, they cannot pay common dividends, so there will be difficulty
raising additional funds, and preferred stockholders may gain control of the firm
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Therefore, preferred often has a
lower before-tax yield than the before-tax yield on debt issued by the same company
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A−T r ps=r ps− [ r ps∗(1−0
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7 ) 40 %]
A−T r ps=0
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09∗(1−0
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4 ]
A−T r ps=0
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92%
A−T rd =(1−T )∗( B−T rd )
A−T rd =(1−40 %)∗(10 %)
A−T rd =(1−0
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1)
A−T rd =0
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1
A−T rd =0
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92 %−6 %
A−T Risk Premium on Preferred=1
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1
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2
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If part of the earnings is retained, an opportunity cost is
incurred: stockholders could have received those earnings as dividends and then invested
that money in stocks, bonds, real estate, and so on
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Jana doesn’t plan to issue new shares of common stock
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0 56+(0
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2= 0
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8 %

e
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What is the estimated cost of equity using the dividend growth approach?
The simplest DCF model assumes that growth is expected to remain constant, and in this
case:
The next expected dividend is easy to estimate, and the stock price can be determined
readily
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Three approaches are commonly used: (1) historical growth rates, (2)
retention growth model, and (3) analysts' forecasts
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12 ( 1+0
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05 8=0
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4 %
P0
P0
$ 50

2
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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
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62)∗0
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38)∗0
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0 5 7=5
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8% rate given earlier
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Could the dividend growth approach be applied if the growth rate were not constant?
How?

lOMoAR cPSD| 3013804

f
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It is logical that a firm with risky, low-rated debt would also have risky,
high-cost equity
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This method provides a ballpark estimate, and it is
generally used as a check on the CAPM and DCF estimates
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rs =¿−own−bond− judgmental risk premium+ ownbond yield

rs =3
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2 %
g
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Method

Cost of equity

CAPM

rs =12
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4 %

Bond-yield-plus-judgmental-risk-premium

rs =13
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8 %+12
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2 %)/3
rs =12
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What is Jana’s weighted average cost of capital (WACC)?
THE WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital (WACC) is calculated using the firm's target capital
structure together with its after-tax cost of debt, cost of preferred stock, and cost of
common equity
...
8 %)
WACC=10

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