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
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Chapter 9 The Cost of Capital 409

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 pre-
• ferred stock is $116.95. There are 200,000 outstanding shares. Jana would incur flota-
• tion 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:'

E)

1. (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
2. 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-pre- mium 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?