Case Study
During the last few years, AJAX Technologies 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 had been proposed by the marketing department. Assume that you are an assistant to Jerry Price, the financial vice president. Your first task is to estimate AJAXs cost of capital. Lee has provided you with the following data, which he believes may be relevant to your task:
1. The firms tax rate is 40 percent.
2. The current price of AJAXs 12 percent coupon, semiannual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. AJAX 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 firms 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. AJAX would incur flotation costs of $2.00 per share on a new issue.
4. AJAXs common stock is currently selling at $50 per share. Its last dividend (D0) was $4.19 and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. AJAXs beta is 1.2; the yield on T-Bonds is 7 percent; the market risk premium is estimated to be 6 percent.
5. AJAXs target capital structure is 30 percent ling term debt, 10 percent preferred stock, and 60 percent common equity.
To structure the task somewhat, Jerry Price has asked you to answer the following questions.
A. What sources of capital should be included when you estimate AJAXs weighted average cost of capital (WACC)?
B. What is the market interest rate on AJAXs debt and its component cost of debt?
C. AJAX does not plan to issue new shares of common stock. Using the CAPM approach, what is the AJAXs estimated cost of equity?
D. What is the estimated cost of equity using the constant dividend model?
E. Suppose the firm has historically earned 15 percent on equity (ROE) and retained 35 percent 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?
F. What is AJAXs WACC?
G. How is any firms stock price (or the value of the firm) related to WACC? Explain in words.
H. How will your estimated WACC be related to increase in expected inflation?
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