During The Last Few Years, Jana Industries Has Been Too Cons

During The Last Few Years Jana Industries Has Been Too Constrained By

During the last few years, Jana Industries has faced significant constraints due to high capital costs, limiting its ability to undertake new investments. However, with recent declines in capital costs, the company is evaluating a major expansion proposal. Your task is to estimate Jana’s cost of capital, considering various sources of capital and their associated costs, to inform the company’s investment decisions.

Specifically, you will determine the components of total capital, calculate their individual costs on appropriate bases, and combine these to estimate Jana’s weighted average cost of capital (WACC). This process involves understanding and computing the costs related to debt, preferred stock, and common equity, as well as accounting for taxes, flotation costs, and risk premiums.

Sample Paper For Above instruction

Introduction

Estimating a company's weighted average cost of capital (WACC) is a fundamental task in corporate finance, serving as a benchmark for evaluating new investment projects. It reflects the average rate that a company must pay to finance its assets through a mix of debt, preferred stock, and common equity, adjusted for risk and tax considerations. Jana Industries’ recent decline in capital costs presents an opportune moment to accurately calculate its WACC, which will be used as a hurdle rate for upcoming expansion projects.

Sources of Capital and Their Inclusion in WACC

When estimating Jana’s WACC, it is essential to consider all sources of long-term financing that the firm uses to fund its operations and growth. These include long-term debt, preferred stock, and common equity. Short-term debt or interest-bearing liabilities are generally excluded unless they are part of the long-term capital structure. The purpose of WACC is to evaluate the cost of the firm's capital that it employs for investments that generate returns over the long term.

Moreover, the component costs should be calculated on a post-tax basis for debt, given the tax deductibility of interest expenses, which effectively lowers the cost for firms. Equity and preferred stock costs are inherently after-tax costs, as these are not tax-deductible. Thus, for consistency and accurate valuation, debt costs must be adjusted to reflect taxes when included in the WACC.

In terms of costs used in the calculation, it is generally preferable to use marginal costs—those associated with new financing—rather than historical or embedded costs. Marginal costs reflect current market conditions and are indicative of the costs the firm will face when raising additional capital. Using historical costs, which are based on past financing, can misrepresent current market realities and lead to inaccurate estimates of WACC.

Market Interest Rate and Component Cost of Debt

Jana's bonds have a current price of $1,153.72, a 12% coupon rate paid semiannually, and 15 years remaining to maturity. Using this data, the yield to maturity (YTM) can be calculated to determine the market interest rate on Jana's debt. Since the bonds are noncallable and current prices reflect market conditions, this YTM effectively represents the market rate of interest for Jana’s debt.

Calculations show that the approximate YTM for Jana's bonds is about 10.07%. For WACC purposes, the component cost of debt is the after-tax YTM, computed as:

Cost of debt after taxes = YTM × (1 - tax rate) = 10.07% × (1 - 0.40) ≈ 6.04%

Cost of Preferred Stock

Jana’s preferred stock has a dividend rate of 10% on a $100 par value and is currently priced at $116.95. The cost of preferred stock is the dividend divided by the net price after flotation costs, which in this case are 5%. The pre-flotation cost yield is:

Cost of preferred stock = (Dividend per preferred share) / (Net proceeds per share)

Accounting for flotation costs, the net proceeds per share are:

Net proceeds = Price × (1 - flotation cost) = $116.95 × (1 - 0.05) = $111.10

Therefore, the cost of preferred stock is:

0.10 × $100 / $111.10 ≈ 9.00%

Despite the fact that preferred stock appears riskier, its lower yield to maturity relative to the debt yield indicates that market perception of risk and tax considerations influence the observed costs. Since preferred dividends are not tax-deductible, this influences their effective cost calculation and risk premium.

Cost of Equity: CAPM Approach

The most common method to estimate the cost of equity is the Capital Asset Pricing Model (CAPM). Using the provided data: beta = 1.2, risk-free rate = 5.6%, market risk premium = 6%, and a risk premium of 3.2% used by Jana itself, helps to triangulate the cost of equity. The CAPM formula is:

Cost of equity = risk-free rate + beta × market risk premium

Substituting values: 5.6% + 1.2 × 6% = 5.6% + 7.2% = 12.8%

This represents the estimated return demanded by investors for holding Jana's equity, accounting for company-specific risk (beta).

Dividend Growth and Risk-Adjusted Equity Cost

The dividend growth approach considers the company's dividends, growth rate, and current stock price. The formula used is:

Cost of equity = (D1 / P0) + g

Where D1 is the expected dividend next year:

D1 = D0 × (1 + g) = $3.12 × 1.058 ≈ $3.30

Thus, the cost of equity based on dividend growth is:

($3.30 / $50) + 0.058 ≈ 0.066 + 0.058 = 12.4%

Interestingly, the dividend growth model and the CAPM produce similar estimates, reinforcing the robustness of the valuation. The model assumes a constant growth rate, which might not be applicable if growth is non-constant, but under stable conditions, it remains a reliable method.

Own-Bond-Yield-Plus-Risk Premium Method

Using the own-bond-yield-plus-judgmental-risk premium approach, the cost of equity is estimated as:

Cost of equity = Bond yield + Risk premium = 10.07% + 3.2% = 13.27%

Final Estimate for Cost of Equity and WACC

Combining all approaches, a reasonable final estimate for the cost of equity would average the CAPM and dividend growth estimates, weighted as appropriate—say approximately 12.6%. The after-tax cost of debt is about 6.04%, and the cost of preferred stock is approximately 9%.

Using a target capital structure of 30% debt, 10% preferred stock, and 60% equity, and adjusting for taxes, the WACC is computed as:

WACC = (wd × rd × (1 - tax rate)) + (wps × rps) + (we × rs)

= (0.30 × 6.04%) + (0.10 × 9%) + (0.60 × 12.6%) ≈ 1.81% + 0.90% + 7.56% ≈ 10.27%

Factors Influencing WACC and Divisional Risks

Multiple factors influence the WACC, including market interest rates, company-specific risks (reflected in beta), capital structure, and tax rates. Changes in these variables alter the perceived cost of capital, impacting investment decisions.

Divisions with different risk profiles require adjusted hurdle rates. The risk-adjusted cost of capital can be estimated through methods such as divisional beta adjustments, comparing similar firms, or using subjective judgment. The beta for a division can be measured using comparable companies or operational risk assessments.

Cost of Capital for New Internet-based Division

For the new division focused on Internet projects, the risk profile is higher, with an average beta of 1.7, and a capital structure of 10% debt and 90% equity with a debt cost of 12%. Using CAPM, the estimated cost of equity is:

5.6% + 1.7 × 6% ≈ 5.6% + 10.2% = 15.8%

Adjusting for the higher leverage and risk, the division’s cost of capital would likely be around 15.8% to 16%, reflecting a higher hurdle rate suitable for high-risk projects.

Conclusion

Estimating Jana’s WACC involves integrating multiple components—debt, preferred, and equity—each derived from market data, adjusting for taxes and flotation costs, and considering firm-specific risks. The comprehensive assessment above provides a sound basis for evaluating new investment opportunities, ensuring the company maintains a competitive and appropriate hurdle rate aligned with its risk profile.

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