During the last few years, ABZ Corporation 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 that has been proposed by the marketing department. Assume that you are an assistant to Mary Mitchell, the financial vice president. Your first task is to estimate ABZ's cost of capital. Mitchell has provided you with the following data, which she believes may be relevant to your task:

(1) The firm's tax rate is 37%.

(2) The current price of ABZ's 13% coupon, semiannual payment, noncallable bonds with 18 years remaining to maturity is $1,200.55. ABZ does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

(3) The current price of the firms 12%, $100 par value, annual dividend, perpetual preferred stock is $159.56. ABZ would incur flotation costs equal to 6% of the proceeds on a new issue.

(4) ABZ's common stock is currently selling at $67 per share. Its last dividend (D0) was $4.02, and dividends are expected to grow at a constant rate of 6.2% in the foreseeable future. ABZ's beta is 1.34, the yield on T-bonds is 4.3%, and the market risk premium is estimated to be 5.8%. For the own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3.1% judgmental risk premium.

(5) ABZ's target capital structure is 26% long-term debt, 8% preferred stock, and 66% common equity.

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

THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH

This approach consists of adding a judgmental risk premium to the yield on the firm's own long-term debt. It is logical that a firm with risky, low-rated debt would also have risky, high-cost equity. Historically, we have observed that the risk premium for equity is in the range of 3 to 5 percentage points. This method provides a ballpark estimate, and it is generally used as a check on the CAPM and dividend growth estimates. This method is used primarily in utility rate case hearings.

Over-own-bond-judgmental risk premium =

Bond yield =

rs =

Judgmental premium

+

Own bond yield

rs =

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