Studocu Is Not Sponsored Or Endorsed By Any College Or Unive

Studocu is not sponsored or endorsed by any college or university Mini case chapter 9 - Juan N Accouting (Bethune-Cookman University)

During recent years, Jana Industries has faced constraints due to high capital costs, limiting its investment activities. However, with declining capital costs, the company is now considering a major expansion, necessitating an accurate estimate of its cost of capital. As an assistant to Leigh Jones, the financial vice president, your task is to determine Jana’s weighted average cost of capital (WACC) using provided financial data.

The key information includes the firm’s tax rate, bond price and maturity, preferred stock details, and common stock data such as current price, dividend, growth rate, and beta. Additional details include the market risk premium, risk-free rate, and the firm's target capital structure proportions. You are to answer specific questions related to sources of capital, component costs, and methods of calculation, covering debt, preferred stock, and common equity—using models such as the Capital Asset Pricing Model (CAPM), dividend growth approach, and the own-bond-yield-plus-judgmental-risk-premium method.

Therefore, the core tasks involve identifying relevant capital sources for WACC calculations, choosing appropriate before-tax or after-tax component costs, calculating the market interest rate on debt and the costs of preferred and common equity (via multiple methods), and assessing how Reinvested Earnings and external equity influence the overall cost. Finally, you need to compute WACC based on target capital structure and discuss factors affecting it.

Paper For Above instruction

In the realm of corporate finance, accurately estimating a company's cost of capital is fundamental for making informed long-term investment decisions. This process involves integrating various sources of capital—including debt, preferred stock, and common equity—each bearing its own risk profile, cost structure, and tax implications. For Jana Industries, recent declines in capital costs have opened opportunities for expansion; hence, a precise WACC estimate becomes critical to evaluate potential projects and strategic initiatives.

Sources of Capital for WACC

The primary sources of capital relevant for calculating Jana’s WACC include long-term debt, preferred stock, and common equity. Short-term liabilities, such as accounts payable and accrued expenses, are generally not incorporated since they are tied to day-to-day operational funding, not long-term investment financing (Brealey, Myers, & Allen, 2020). However, if a firm utilizes interest-bearing short-term debt for capital expenditures, that aspect would warrant inclusion. Since Jana does not rely on the short-term interest-bearing debt for permanent capital, the focus remains on long-term debt, preferred stock, and common equity, aligning with standard practice in capital budgeting (Ross, Westerfield, & Jaffe, 2019).

Component Costs: Before-tax versus After-tax

Component costs should be calculated on an after-tax basis, especially for debt, because interest expenses are tax-deductible, providing a tax shield (Damodaran, 2015). This affects the effective cost to the company, making debt cheaper after tax considerations. For preferred stock and equity, which do not benefit from tax deductions, their costs are computed on a pre-tax basis, but from a valuation standpoint, the costs are typically expressed as what is required by investors, reflecting their after-tax expectations (Berk & DeMarzo, 2020).

Historical versus Marginal Costs

The relevant costs for WACC purposes are marginal costs, representing new capital raising costs, rather than historical embedded costs. This ensures that investment decisions reflect the current market conditions and the true cost of obtaining additional funds (Brealey, Myers, & Allen, 2020). Using marginal costs provides a more accurate basis for evaluating whether a project’s return exceeds the minimum hurdle rate derived from the estimated WACC.

Calculating the Cost of Debt

Jana’s bonds, with a coupon rate of 12%, are currently trading at a premium at a price of $1,153.72. Using the bond’s market price, coupon payments, and time to maturity, the yield to maturity (YTM) is computed to estimate the market interest rate. Based on the given data and a standard financial calculator or Excel's RATE function, the YTM approximates 10%. Adjusting for the corporate tax rate of 40%, the after-tax cost of debt becomes 6% (YTM × (1 - Tax rate)), aligning with textbook finance principles (Ross et al., 2019).

Cost of Preferred Stock

The cost of preferred stock is calculated as the preferred dividend divided by the net issuing price, factoring in flotation costs. Given a 10% dividend rate on a $100 par value, the annual preferred dividend is $10. With a net proceeds of 95% × $116.95 (i.e., $111.10), the cost becomes approximately 9.0%. Preferred stock's riskier profile compared to debt is reflected in its higher required return for investors, but its lower yield to investors compared to debt (before tax) is influenced by the tax treatment of dividends received by corporate investors. Since dividends are not tax-deductible, preferred stock carries higher risk premiums, which are partly mitigated by favorable tax treatment for corporate investors (Graham & Harvey, 2001; Damodaran, 2015).

Cost of Common Equity

There are two primary ways for firms to raise common equity: (1) by retaining earnings and reinvesting them in the business and (2) by issuing new common stock in the capital markets (Ross et al., 2019). The cost of reinvested earnings corresponds to the opportunity cost of reinvesting capital, reflected in the required return by shareholders, typically estimated via models such as CAPM and dividend growth models.

Using CAPM, Jana’s cost of equity is derived from the risk-free rate, beta, and market premium:

\[ r_{e} = R_{f} + \beta (R_{m} - R_{f}) \]

substituting the values:

\[ r_{e} = 5.6\% + 1.2 \times 6\% = 12.8\% \]

This encapsulates the market risk premium adjusted for Jana’s specific beta, aligning with investor expectations (Berk & DeMarzo, 2020).

Dividend Growth Approach

The dividend growth model (DGM) estimates the cost of equity based on expected dividends and growth rate:

\[ r_{e} = \frac{D_{1}}{P_{0}} + g \]

where \( D_{1} = D_{0} \times (1+g) \). With \( D_{0} = \$3.19 \), \( P_{0} = \$50 \), and \( g = 5.8\% \),

\[ r_{e} = \frac{3.19 \times (1 + 0.058)}{50} + 0.058 \approx 12.8\% \]

This matches the CAPM estimate, providing robustness to the calculation (Gordon, 1959; Damodaran, 2015).

Own-bond-yield-plus-judgmental-risk-premium Method

This approach involves adding a risk premium (typically 3-5%) to Jana’s own long-term bond yield. The bond yield on Jana’s debt is 10%, and adding a risk premium of 3.2% results in a cost of equity around 13.2%. This method provides a conservative estimate and is useful as a cross-check against other models (Damodaran, 2015).

Final Cost of Equity and WACC Calculation

By averaging the estimates from CAPM (12.8%), dividend growth (12.8%), and bond-yield-plus-risk-premium (13.2%), the final estimated cost of equity is approximately 12.9%. Using Jana’s target capital weights — 30% debt, 10% preferred, and 60% equity — the WACC computes as:

WACC = (E/V) × rₑ + (D/V) × rₓ × (1 - T) + (P/V) × rₚ

Substituting:

\[ \text{WACC} = 0.60 \times 12.9\% + 0.30 \times 6\% + 0.10 \times 9\% = 7.74\% + 1.8\% + 0.9\% \approx 10.44\% \]

This estimate enables Jana to assess the viability of expansion projects considering the cost of obtaining capital under current market conditions.

Factors Influencing WACC

Several factors affect a company’s WACC, including market interest rates, the company's creditworthiness influencing bond yields, tax rates, and the proportions of each capital component in the target structure. Changes in these factors alter the overall cost of capital, impacting strategic decision-making and investment evaluations (Brealey et al., 2020; Ross et al., 2019).

Conclusion

In summary, calculating Jana Industries' WACC involves integrating multiple sources of capital, each with its own cost structure and risk profile. Employing diverse estimation methods enhances the reliability of the estimate, aiding strategic investment decisions. As capital costs decline, accurately assessing WACC becomes increasingly vital to capitalize on growth opportunities and optimize capital structure for long-term value creation.

References

• Berk, J., & DeMarzo, P. (2020). Corporate Finance (5th ed.). Pearson.
• Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
• Damodaran, A. (2015). Applied Corporate Finance (4th ed.). Wiley.
• Gordon, M. J. (1959). Dividends, earnings, and stock prices. Review of Economics and Statistics, 41(2), 99–105.
• Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187–243.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.