| Chapter 9: Mini Case |
| a. | 1) Stock that should be included when estimating Jana's WACC is bonds, preferred stock and common stock. |
| | 2) The component cost should ideally be figured out after-tax basis since dividends are paid and reinvestment is made with after-tax dollars. |
| | 3) The cost should be the new marginal) costs |
| b. | 10%*(1-40%)= | | 6% |
| c. | 1) Firms cost of preferred stock: |
| | 10/116.95= | | 8.55% |
| | 2) After-tax cost of debt is lower than the cost of the preferred stock, which means that the preferred stock is actually a higher risk than the debt. |
| d. | 1) The two common ways that companies raise common equity is either directly, by issuing new common shares or stocks. Or indirectly, by using retained earnings. |
| | 2) There is a cost associated with reinvested earnings since that causes shareholders incur an opportunity cost. If those retained earnings were paid as dividends, shareholders would have had the opportunity to invest those earnings in other stocks. |
| | 3) CAPM Approach: |
| | 5.6% + (1.2 * 6%)= | | 12.8% |
| e. | 1) Dividend growth approach: |
| | [[$3.12(1+5.8%)]/$50] +5.8%= | | | 12.4% |
| | 2) ROE: 15%; Payout Rate: 62% |
| | G=(1-62%)(15%)= | | 5.7% |
| | The 5.7% future dividend growth rate does fall consistent with the 5.8% growth rate. |
| | 3) Yes, the dividend growth rate could still be applied even if the growth rate was not consistent, the PV of the dividends during the non-constant growth period can be calculated and added to the PV of the series of inflow during the constant growth. |
| f. | own-bond-yield-plus-judgmental risk premium = 3.2% |
| | Semiannual YTM = YTM/2 |
| | N=30 | PV=$1153.72 | | PMT=60 | FV=$1000 |
| | YTM/2=(60+((1000=1153.72)/30) (1000+1153.72)/2) |
| | YTM=5%*2=10% |
| | Cost of Equity= 10%+3.2%= | | | 13.2% |
| g. | Approach | | | Formula | | | Cost of equity |
| | CAPM | | | 5.6%+(1.2*6%)= | | | 12.8% |
| | DCF | | | ((3.12*(1+5.8%))/50)+5.8%= | | | 12.4% |
| | bond-yield-plus-risk-premium | | | 10%+3.2%= | | | 13.2% |
| | Average | | | (12.8%+12.4%+13.2%)/3= | | | 12.8% |
| h. | WACC=(30%*6%)+(10%*9%)+(60%*12.8%)= | | | | | 10.38% |
| i. | Factors that influence a company's WACC: |
| | Uncontrollable: | | Market Conditions |
| | | | Market risk premium |
| | | | Tax Rate |
| | Controllable: | | Capital structure policy |
| | | | Dividend policy |
| | | | Investment policy |
| j. | No, different investments tend to have different risks assocaited with them meaning that WACC has to be asjusted accordingly to the risk. |
| k. | Subjective adjustment to he composite WACC as well as attempting in making estimation about the cost of capital in case stand-alone company and estimation of the division beta can be used when it comes to determining the risk-adjusted capital cost. |
| | The proxy play approach or the accounting betta apprach can be used when it comes to measuring a division's beta. |
| l. | Debt: 10% | | Equity: 90% | | Cost of dept: 12% | | Beta: 1.7 |
| | Cost of equity=5.6%+(1.7*6%)= | | | 15.8% |
| | WACC=(12%*.10*(1-.40))+(90%*15.8%)= | | | | 14.94% |
| | Based on the above calculation, it shows that the cost of capital has increased to what it was before. This indicates an increase in risk by changing the capital strcuture of the company. Only projects/investments that will generate a return of 14/94% or greater will be accepted. |
| m. | The three types of project risk are stand alone risk, corporate risk and market risk. |
| | Stand alone risk: | | Total risk if operated independently, measured by standard deviation. |
| | Corporate risk: | | The variability of a project contributes to a corporation's stock returns. |
| | Market risk: | | The part of a project that cannot be eliminated by diversification. |
| n. | One of the main reasons for a firm to raise fund is that they are then able to explore other investment opportunites. The amount raised then becomes associated with the costs which based on the required rate of return and has an opportunity cost. The new investment should be of more or equal value to other investment opportunities that are being considered. |
| o. | 1) Next year dividend =$3.12*(1+.058)= | | | | $ 3.30 |
| | Price of stock = $50*(1-.15)= | | | $ 42.50 |
| | Cost of equity = ($3.30/$42.5)+.058= | | | | 13.56% |
| | 2) PV:$1000 | | NPER: 30 Years | | Coupon rate: 10% | | Floating costs: 2% |
| | PV of Debt = $1000*(1-.02)= | | | $ 980 |
| | Coupon=$1000*10%= | | | $ 100 |
| | Yield=RATE(30,100,-980,1000)= | | | 10.22% |
| | Cost of debt=10.22%*(1-.40)= | | | 6.13% |
| p. | Jana should avoid the four following mistaks: |
| | 1. Use the current cost of debt rather that the coupon rate |
| | 2. The historical average return should not be subtracted from the risk-free rate directly when it comes to determining the cost of equity using the CAPM approach. |
| | 3. Use the market value rather that the book value when it comes to determining the weights as it gives a better use to the target capital strcture when compared to the historical information. |
| | 4. The only capital that shouldbe considered is the capital that us raised from the investors for investing purposes. |
Yuzhi Zhao
FIN609A__W2_Mini_Case.xlsx
