Mini Case Ch9

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 40%.
• The current price of Janas 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 firms 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.
• Janas 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. 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.
• Janas target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity. To help you structure the task, Leigh Jones has asked you to answer the following questions.

a. (1) What sources of capital should be included when you estimate Janas weighted average cost of capital? (2) Should the component costs be figured on a before-tax or an after-tax basis? (3) Should the costs be historical (embedded) costs or new (marginal) costs?

b. What is the market interest rate on Janas debt, and what is the component cost of this debt for WACC purposes?

c. (1) What is the firms cost of preferred stock? (2) Janas preferred stock is riskier to investors than its debt, yet the preferred stocks yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

d. (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?