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 preferred stock is $116.95. There are 200,000 outstanding shares. Jana would incur flotation 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 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.

What is the cost of equity based on the own-bond-yield-plus-judgmental-risk-premium method? Please show your full work in excel.

Answer #1

cost of equity based on the own-bond-yield-plus-judgmental-risk-premium method=yield on bonds+judgemental risk premium

We have to find the yield on bonds using RATE function in Excel

=RATE (nper,pmt,pv,fv,type)

Please remember that the payments are semi annual

nper=15*2=30

Pmt=semi annual coupon=(coupon rate*face value)/2=(12%*1000)/2=120/2=60

pv=1153.72

fv=1000

=RATE (30,60,-1153.72,1000,0)=5%

Annual yield=2*5%=10%

Yield after tax=10%*(1-tax rate)=10%*(1-25%)=7.5%

Cost of equity=7.5%+3.2%=10.7%

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