Reference no: EM133027485
FINANCE - FIN 6310 Weighted Average Cost of Capital (WACC) Case Study - Jana Industries Inc.
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 estimate Jana's cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:
1. The firm's tax rate is 40%.
2. The current price of Jana's 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Jana does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
3. The current price of the firm's 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Jana would incur flotation 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 (D0) 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 over-own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 3.2% judgmental risk premium.
5. Jana's target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
To help you structure the task, Leigh Jones has asked you to answer the following questions.
1. What is the market interest rate on Jana's debt, and what is the component cost of this debt for WACC purposes?
2. What is the firm's cost of preferred stock?
3. Jana doesn't plan to issue new shares of common stock. Using the CAPM approach, what is Jana's estimated cost of equity? What is the estimated cost of equity using the dividend growth approach?
4. Suppose the firm has historically earned 15% on equity (ROE) and retained 62% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5.8% growth rate given earlier?
5. What is the cost of equity based on the bond-yield-plus-judgmental-risk-premium method? What is your final estimate for the cost of equity, rs?
6. What is Jana's weighted average cost of capital (WACC)?
7. Should the company approve or reject any new project with similar level of risk if the required rate of return is 14.5%?