premium method? 85 THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH 36 87 This approach consists of adding a judgmental risk premium to the yield on the firm's own long-term debt. It is logical that a firm with 88 risky, low-rated debt would also have risky, high-cost equity. Historically, we have observed that the risk premium for equity is in the range 89 of 3 to 5 percentage points. This method provides a ballpark estimate, and it is generally used as a check on the CAPM and dividend 190 growth estimates. This method is used primarily in utility rate case hearings. 191 192 Over-own-bond-judgmental risk premium 193 Bond yield- 194 195 Judgmental Own bond 196 premium yield 197 1985 199 200 g. What is your final estimate for the cost of equity,,? 201 202 THE COST OF EQUITY ESTIMATE 203 it is common to use several methods to estimate the cost of equity, and then find the average of these methods. 204 205 Method Cost of Equity 206 CAPM - 207 Constant dividend growth: 208 Bond-yield-plus-judgmental-risk-premium: - 200 210 213 Averager, 211 212 THE WEIGHTED AVERAGE COST OF CAPITAL 214 h. What is Jana's weighted average cost of capital (WACC)? 215 215 T- 217 Wa 218 219 220 WACC = 33 234 ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTS 35 236 237 238 239 P,- D- D- 240 241 242 D P g 243 244 245 246 247 Flotation percentage cost (F) - Stock price 248 (1-F Net proceeds after flotation costs (Stock Price) Net proceeds after flotation costs Net proceeds after flotation costs 249 250 251 252 253 254 255 256 257 Net proceeds after flotation costs D.- D Net Proceeds 258 259 260 11 13 Situation 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 that has been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to 0 estimate Jana's cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task: 12 (1) The firm's tax rate is 35%. 14 (2) The current price of Jana's 11% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Jana 15 does not use short-term Interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. 16 (3) The current price of the firm's 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Jana would incur flotation 17 costs equal to 5% of the proceeds on a new issue. (4) Jana's common stock is currently selling at $50 per share. Its last dividend (D) was $3.10, 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 19 be 6%. For the own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3% judgmental risk premium. 20 (5) Jana's target capital structure ls 35% long-term debt, 10% preferred stock, and 55% common equity. 22 To help you structure the task, Leigh Jones has asked you to answer the following questions. 18 21 23 24 25 .. (1.) What sources of capital should be included when you estimate Jana's weighted average cost of capital (WACC)? 27 Answer: Bonda, Preferred Stock, and Common Stock 26 28 29 31 30 (2.) should the component costs be figured on a before-tax or an after-tax basis? 32 Answer: The component conts should be figured on an after-tax basis. (3.) Should the costs be historical (embedded) costs or new (marginal costs? 37 Answer: The costs should be the new marginal costs. 35 38 39 b. What is the market interest rate on Jana's debt and what is the component cost of this debt for WACC purposes? 41 COST OF DEBT