Chapter 9: The Cost Of Capital Mini Casebook

Chapter 9 The Cost Of Capital Mini Casebook Title Financial Manageme

Estimate Jana’s cost of capital by considering relevant sources of capital, calculating component costs on an appropriate basis, and accounting for taxes and new issue costs. Use the provided data such as bond prices, preferred stock prices, dividend growth rates, and market data to determine the costs of debt, preferred stock, and equity. Adjust for flotation costs where necessary. Calculate the weighted average cost of capital (WACC) based on Jana’s target capital structure, and discuss factors influencing WACC. Address the appropriateness of using the overall WACC as a hurdle rate for divisions and procedures for estimating division-specific risk-adjusted costs. Evaluate the risk factors associated with new divisions, including Internet-based projects, and adjust the cost of capital estimates accordingly. Discuss why external equity has a higher percentage cost than retained earnings, incorporating flotation costs, and provide the final estimates for the cost of equity and debt. Highlight common mistakes to avoid when estimating WACC. Consider how project risks impact the cost of capital and how to incorporate these into decision-making for capital investments.

Paper For Above instruction

The estimation of a firm's cost of capital, particularly the weighted average cost of capital (WACC), is a fundamental component of corporate finance decision-making. It reflects the minimum return that a company must earn on its existing asset base to satisfy its investors and creditors. Accurately calculating the WACC involves identifying all relevant sources of capital, determining their individual costs, and appropriately weighting these costs based on the firm's target capital structure.

Sources of Capital and Cost Basis

The primary sources of capital that should be included when estimating Jana’s WACC are debt, preferred stock, and common equity. These components, representing long-term financing, are typically used for major investment decisions. When calculating component costs, it is essential to consider whether to use pre-tax or after-tax figures. Since interest expenses on debt are tax-deductible, tax adjustments are necessary to reflect the true cost to the company. Generally, the after-tax cost of debt provides a more accurate measure for WACC calculations, as it considers the tax shield benefits.

Historical vs. Marginal Costs

Deciding between historical (embedded) costs and new (marginal) costs is critical. While historical costs are based on past financing activities, they may not reflect current market conditions or the cost of new capital issuance. For decision-making purposes, the marginal cost—what the firm would incur for new financing—is more relevant. Therefore, in the context of Jana, marginal costs should be used to estimate the current WACC.

Market Interest Rate on Debt and Cost of Debt

Using the bond data provided, the current market interest rate, or yield to maturity (YTM), on Jana's debt can be estimated from the bond's price, coupon rate, and time to maturity. Given the bond price of $1,153.72, a coupon rate of 12%, semiannual payments, and 15 years remaining, the YTM can be calculated through iterative methods or financial calculator tools. The approximate YTM is around 10%, which constitutes the component cost of debt before tax adjustments. Adjusting for a 40% tax rate, the after-tax cost of debt would be approximately 6% (i.e., 10% × (1 - 0.40)).

Cost of Preferred Stock

The cost of preferred stock is calculated by dividing the dividend per share by the net price per share after flotation costs. Given a quarterly dividend of $10 (annual $40) and a price of $116.95, the yield to preferred investors is roughly 34.18%. However, since flotation costs of 5% are incurred, the net proceeds per share are $111.11, leading to a preferred stock cost of approximately 36% (i.e., $40 / $111.11). The higher yield than the debt's yield indicates that preferred stock is riskier, despite a lower yield, due to its subordinate position in capital structure and risk profile.

Cost of Equity: Capital Asset Pricing Model (CAPM)

The CAPM approach estimates the cost of equity by considering the risk-free rate, the firm-specific beta, and the equity risk premium. Using a risk-free rate of 5.6%, a beta of 1.2, and a market risk premium of 6%, the cost of equity computes as: 5.6% + (1.2 × 6%) = 12.8%. This method captures the systematic risk inherent in Jana’s equity, which is crucial for investment assessment and valuation.

Dividend Growth Model and Growth Rate Estimations

The dividend growth approach estimates the cost of equity based on the last dividend, the expected growth rate, and current stock price. Given a last dividend of $3.12 and a growth rate of 5.8%, the cost of equity is calculated as:

\( \text{Cost} = \frac{D_1}{P_0} + g = \frac{3.12 \times (1 + 0.058)}{50} + 0.058 \approx 12.4\% + 5.8\% = 18.2\% \).

Alternatively, considering the firm's historical ROE of 15% and payout ratio of 62%, the retained earnings reinvested generate a growth rate similar to the sustainable growth rate, \( g = \text{ROE} \times (1 - \text{payout ratio}) = 15\% \times 0.38 = 5.7\% \). This aligns with the given growth rate of 5.8%, demonstrating consistency between dividend growth estimates and company earnings behavior. The dividend growth method presumes constant growth, but in cases where growth rates change, alternative models like the non-constant growth or multi-stage dividend discount models should be used.

Own-Bond-Yield-Plus-Risk Premium Method

Using this approach, the cost of equity is the sum of the firm's bond yield and a judgmental risk premium. Given a bond yield of approximately 10%, and a risk premium of 3.2%, the estimated cost of equity becomes roughly 13.2%. This method reflects the additional risk investors associate with equity compared to debt, emphasizing the firm's relative risk profile.

Final Estimate of Cost of Equity and WACC

Combining the methods and considerations, an appropriate estimate for Jana’s cost of equity is around 12.8% to 13.2%, based on CAPM and bond-yield-plus-premium approaches. For a conservative and balanced estimate, adopting 13% is reasonable. The WACC then is calculated as:

WACC = (0.30 × 6%) + (0.10 × 36%) + (0.60 × 13%) = 1.8% + 3.6% + 7.8% = 13.2%.

Influences on WACC and Application in Divisional Decisions

Factors influencing WACC include market conditions, firm-specific risk, capital structure, tax rates, and the risk profile of particular projects or divisions. It is generally inappropriate to use the overall WACC as the hurdle rate for all divisions because different areas of a company face varying levels of risk. A division involved in riskier Internet-based projects would typically require a higher hurdle rate, adjusted for its specific risk profile. Methods for estimating division-specific risk include adjusting betas based on comparable firms, regression analyses, or the build-up method.

Assessing New Project and Division Risks

The new division focusing on Internet projects displays higher systematic risk, with a beta of 1.7, and uses a different capital structure (10% debt, 90% equity). The cost of equity for this division can be estimated via CAPM: 5.6% + (1.7 × 6%) = 16.4%. Incorporating the higher leverage and risk factors, the division’s WACC would be approximately:

WACC = (0.10 × (12%) × (1 - 0.40)) + (0.90 × 16.4%) ≈ 0.72% + 14.76% ≈ 15.5%.

There are three primary project risks: business risk (market competition, technology), financial risk (leverage and debt levels), and economic risk (industry and macroeconomic factors). Each must be articulated into the cost of capital to reflect true risk-adjusted hurdle rates, ensuring that investments are evaluated fairly across varying risk profiles.

Cost Difference for External vs. Internal Equity

External equity issued through new stock offerings bears a higher percentage cost than retained earnings due to flotation costs—expenses associated with underwriting, legal, and administrative processes—and the dilution of existing ownership. These costs add to the required return investors seek to compensate for the additional issuance risks. For example, with a 15% flotation cost, the calculated cost of new equity using the dividend growth model becomes:

Cost = \(\frac{D_1}{P_0 \times (1 - \text{flotation rate})} + g = \frac{3.12 \times 1.058}{50 \times 0.85} + 0.058 \approx 19.7\% + 5.8\% = 25.5\%\).

Incorporation of Flotation Costs and Cost of Debt

When issuing debt with a par value of $1,000, a coupon rate of 10%, and flotation costs of 2%, the after-tax cost becomes approximately 7.8% (i.e., 10% × (1 - 0.40) minus flotation costs). This reflects the actual expense to the company for new debt issuance, emphasizing the importance of factoring in flotation costs in capital budgeting.

Common Mistakes and Best Practices in Estimating WACC

Jana should avoid four common mistakes: neglecting taxes when calculating the after-tax cost of debt, using embedded costs instead of marginal costs, ignoring risk differences among divisions, and assuming a constant capital structure or market conditions. Proper procedures include using current market data, adjusting for firm-specific risks, employing division-specific betas, and consistently updating estimates to reflect changing economic environments.

Conclusion

Estimating the cost of capital is a comprehensive process that integrates market data, firm-specific factors, and strategic considerations. An accurate WACC facilitates optimal capital budgeting, ensures fair valuation of projects, and informs dividend and financing policies. For Jana Industries, carefully integrating debt, preferred, and equity costs, while accounting for risk differentials across divisions and new projects, leads to better investment decisions and long-term value creation.

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