Principles of Finance I Assignment 4

The WACC is mainly used in making an investment choice that serves for a long period of time also called long term. Thus, the WACC should involve the different types of payment options used to pay for assets acquired for a long period of time in form of debt, a preferred stock and a common stock. Capital acquired in a short period of time includes a liability and debt which does not bear interest.

• Principles of Finance I Assignment 4
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• Principles of Finance I Assignment 4
  • (1) What sources of capital should be included when you estimate Jana’s weighted average cost of capital?

  A company should involve a debt component for a short period when it uses a debt which has an interest bearing for a short period of time to buy fixed assets rather than financing the capital needs for work. The debt which does not bear interest is usually not used when estimating cost of capital because the net capital is used in capital expenses rather than gross capital.

  (2) Should the component costs be figured on a before-tax or an after-tax basis?

  The component costs should be figured after tax basis. This is because the Stockholders usually put more effort and interest in corporate cash flows that are easily accessible to them to use. These cash flows are usually used by the stockholders to reinvest or for the payment of dividends, this makes it clear that the after tax dollars is used for reinvestment.

  (3) Should the costs be historical (embedded) costs or new (marginal) costs?

  The costs should be marginal costs because they are the component costs considered relevant. The cost of capital is usually used in raising new capital and deciding on tasks that involve contributing the capital.

  The market interest rate is 10%.

  • What is the market interest rate on Jana’s debt, and what is the component cost of this debt for WACC purposes?

  The interest is usually taxed, and the component cost of debt in question is the after-tax cost. (JB Heaton, 2002)

  The preferred stock issue is perpetual. This is because the floatation costs for the preferred stock are important. There is also no reason to make changes in tax since the dividends acquired from the preferred stock are not made to be any less to the issuer. Nominal cost is always used to determine the debt’s cost at a yearly basis. (A Saunders, MM Cornett, 2003)

  • (1) What is the firm’s cost of preferred stock?

  (2) Jana’s preferred stock is riskier to investors than its debt, yet the preferred stock’s yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake?

  No, it does not suggest that I have made a mistake. Most investors found in the corporate world have most preferred stock because a large percentage is usually not taxed. This thus makes the preferred stock have a low before tax yield than that which is given on the company’s debt. (GM Bodnar, GS Hayt, RC Marston, 1998)

  (1) What are the two primary ways companies raise common equity?

  ​A company can acquire common equity in two ways, either by retaining earnings or by giving out new common stock in the market.( JB Heaton, 2002)

  (2) Why is there a cost associated with reinvested earnings?

  ​There is cost associated with reinvested earning because there is an opportunity of the cost being incurred. The management can either use dividends to pay for their earnings or decide to hold on to their earnings and put it back to business and earn more money. (A Saunders, MM Cornett, 2003)

  (3) Jana doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Jana’s estimated cost of equity?

  Reference

  • ​rs = 0.07 + (0.06)1.2 = 14.2%.

  A Saunders, MM Cornett, (2003), Financial institutions management: A risk management approach.

  JB Heaton, (2002), Managerial optimism and corporate finance: Financial management.

  GM Bodnar, GS Hayt, RC Marston, (1998), 1998 Wharton Survey of financial risk management by US non-financial firms: financial management