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2 Excel Module Week 4 - Cost of Capital (20 points)

3 Situation
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6 During the last few years, Jana Industries has been too constrained by the high cost of capital to make
7 many capital investments. Recently, though, capital costs have been declining, and the company has
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decided to look seriously at a major expansion program that has been proposed by the marketing
department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first
9 task is to estimate Jana's cost of capital. Jones has provided you with the following data, which she
10 believes may be relevant to your task:
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12 A. The firm's tax rate is 40% and its before tax cost of debt is 10%
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B. The current price of Jana's 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to
15 maturity is $1,153.72. Jana does not use short-term interest-bearing debt on a permanent basis. New bonds
16 would be privately placed with no flotation cost.
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18 C. The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95.
19 Jana would incur flotation costs equal to 5% of the proceeds on a new issue.
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D. Jana's common stock is currently selling at $50 per share. Its last dividend (D ) was $3.12, and dividends are
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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
23 5.6%, and the market risk premium is estimated to be 6%. For the own-bond-yield-plus-judgmental-risk-premium
24 approach, the firm uses a 3.2% judgmental risk premium.
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26 E. Jana's target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
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28 To structure the task, Leigh Jones has asked you to answer the following questions.
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30 1. Explain what sources of capital should be included when you estimate Jana's weighted average cost
31 of capital (WACC)? (1 point)
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33 WACC is the average return required by all of the firms investors, determined by the firm's capital structure, interest
34 rates, its risk and market's attitude towards the risk. The calculation includes common stock, long term debt, bonds
35 and preferred stock. WACC is primarily used for some long term capital investement decisions.
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38 As a source, Jana can use the WACC equation:
39 WACC= ((E/V) x Re) + ((D/V) x Rd x (1-Tc))
40 Re= cost of equity,Rd = cost of debt, E = market value of the firm's equity, D = market value of the firm's debt, V=E+D=2
41 Tc = Corporate tax rate
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44 2. Explain whether the component costs be figured on a before-tax or an after-tax basis?
45 (1 point)
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46 The component costs should be done on an after-tax basis. Dividents are paid on reinvestments made with after-tax
47 dollars, therefore all calculations of cash flow and rates of return should be done on an after-tax basis.
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55 3. Explain whether the costs be historical (embedded) costs or new (marginal) costs & WHY?
56 (HINT: "costs" refer to cost of capital, cost of preferred stock, and cost of common equity (1 point)
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58 The costs should be new marginal rather than historical. It is due to capital costs primarily used in making decisions
59 that require raising new capital.
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64 4. What is the before and after tax cost of debt? (2 points)
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66 COST OF DEBT, rd
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68 Before Tax Cost of Debt = B-T rd = 6(1-0.10)=6(0.9)= 5.4%
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70 After Tax Cost of Debt = A-T rd = ( 1 - Tax Rate) x (B-Trd)
71 6(1-0.40)=6(0.6)= 3.6%
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75 5. What is the firm's cost of preferred stock? (2 points)
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77 Explain and calculate the firm's cost of preferred stock
78 Firms use preferred stock as part of their financing mix. A company takes care of full cost since the preferred
79 dividends are not tax deductible. Nowadays many firms have a sinking fund which would limit its life. Firms try to pay
80 their preferred dividends and if that would to fail, common stock payouts would not be met, failure to raise additional
81 funds in the capital markets and in some cases stockholders could take control of the firm.
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86 Pref. Dividend $10.00
87 Pref. Price (Pps) $116.95
88 Flotation costs (F) 5%
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90 rps = Pref. Dividend ÷ Pps(1 – F)
91 10/((116.95(1-5) = 8.93%
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95 COST OF EQUITY (INTERNAL), rs
96 6. What are the two primary ways companies raise common equity? (1 point)
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98 Two primary ways the companies rainse common equity are by retaining earningd and by issuing new commn stock.
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105 7. Why is there a cost associated with reinvested earnings? (1 point)
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107 While the earnings are reinvested, the stockholders would receive the funds in order to reinvest in other securities.
108 The firm then should earn on its reinvested earnings as stockholders earn on alternative investements of
109 equivalent risk.
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116 8. Jana doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Jana's
117 estimated cost of equity? (2 points)
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119 The CAPM Approach
120 rs = Risk-free rate + (Market risk premium) (Beta)
121 rs = rRF + (RPM) bi (Note: RPM is the expected return on the market minus the risk-free rate.)
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123 PROBLEM
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125 Assuming the risk-free rate (i.e., the current yield on a long-term Treasury bond) equals 5.6%, the
126 expected market risk premium is 6%, and the firm's beta is 1.2, what is the company's cost of equity
127 from internal funds?
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129 Risk-free rate (rRF) 5.6%
130 Expected market risk premium (RPM 6%
131 Beta (bi) 1.2
132 Cost of Equity (rs) ???
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134 rs = rRF + (RPM) x (bi) = CAPM formula
135 rs = 0.056 + (0.06)1.2 = 12.8%
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137 rs = Cost of Equity
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