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: 


1. Jana is interested in establishing a new division that will focus primarily on develop- ing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that specialized firms involved in similar projects have, 
on average, the following characteristics: Their capital structure is 10% debt and 90% common equity; their cost of debt is typically 12%; and they have a beta of 1.7. Given this information, what would your estimate be for the new division’s cost of capital?

Answer 1

Solution) Risk-free rate (Rf) = Yield on T-bonds = 5.6%

Market risk premium (Rm - Rf) = 6%

Beta of division = 1.7

Cost of equity (Re) for division can be calculated using the Capital Asset Pricing Model (CAPM) as:

Re = Rf + Beta(division) *(Rm - Rf)

Re = 5.6% + 1.7*(6%)

Re = 5.6% + 10.2%

Re = 15.8%

Weighted Average Cost of Capital of Division (WACCdivision) is calculated as:

WACCdivision = Wd*Rd*(1 - Tax%) + We*Re

Wd = Weight of debt = 10%

Rd = Cost of debt = 12%

Tax% = 25%

We = Weight of equity = 90%

Re = Cost of equity = 15.8%

WACCdivision = 10%*12%*(1-25%) + 90%*15.8%

WACCdivision = 10%*12%*75% + 90%*15.8%

WACCdivision = 0.009 + 0.1422 = 0.1512 = 15.12%

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