What four common mistakes in estimating the WACC should Jana avoid?

Question

To help you structure the task, Leigh Jones has asked you to answer the following questions.

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.

Answer 1

1. Don’t use the coupon rate on a firm’s existing debt as the pre-tax cost of debt. Use the current cost of debt.

2. When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on stocks.
For example, the historical average return on stocks has been about 12.7%. If inflation has driven the current risk-free rate up to 10%, it would be wrong to conclude that the current market risk premium is 12.7% – 10% = 2.7%. In all likelihood, inflation would also have driven up the expected return on the market. Therefore, the historical return on the market would not be a good estimate of the current expected return on the market.

3. Don’t use book weights to estimate the weights for the capital structure. Use the target capital structure to determine the weights for the WACC. If you don’t have the target weights, then use market value rather than book value to obtain the weights. Use the book value of debt only as a last resort.

4. Always remember that capital components are sources of funding that come from investors. If it’s not a source of funding from an investor, then it’s not a capital component.