Question

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 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:

What is your final estimate for the cost of equity, rs? 


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?

Use Jana’s target weights to calculate the weighted average cost of capital (WACC).

Answer 1

Cost of Debt :-

= Debt Interest Rate * ( 1 - Tax Rate)

= 12% * (1 - 0.25)

= 12% * 0.75

= 9%

Cost of Preferred Stock :-

= (Preferred Dividend / Market Price) * (1 - flotation Cost)

= ($10 / $116.95) * (1 - 0.05)

= ($0.0855066) * (0.95)

= 0.0812 or 8.12%

Cost of Equity :-

D0 = $3.12

g = 5.8%

P0 = $50 per share

= ((D0 * (1 + g)) / P0) + g

= (($3.12 * (1 + 0.058)) / $50) + 0.058

= (($3.12 * 1.058) / $50) + 0.058

= ($3.301 / $50) + 0.058

= 0.066 + 0.058

= 0.124 or 12.4%

WACC :-

Particular	Cost of Capital (A)	Capital Structure (B)	A*B
Debt	9%	30%	2.7%
Preferred Stock	8.12%	10%	0.812%
Common Stock	12.4%	60%	7.44%
WACC			10.95%