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 Janas cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:

The firms tax rate is 25%.

The current price of Janas 12% coupon, semian-nual payment, and 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 firms 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.

Janas common stock is currently selling at $50 per share. There are 3 million outstanding common shares. Its last dividend (D0 ) was $3.12, and divi-dends are expected to grow at a constant rate of 5.8% in the foreseeable future. Janas 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.

Answer the followings:

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

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

(3) Jana doesnt plan to issue new shares of common stock. Using the CAPM approach, what is Janas estimated cost of equity?

b. (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?