Solution to Case 04

Determining the Cost of Capital

Can One Size Fit All?

Questions: 1. Why do you think Larry Stone wants to estimate the firms hurdle rate? Is it justifiable to use the firms weighted average cost of capital as the divisional cost of capital? Please explain. Larry wants to estimate the firms hurdle rate because it would provide him with a yardstick with which to measure the feasibility of future investment proposals. The firm had thus far been using a gut feel approach and although most of the decisions had turned out to be good ones, Larry was rightfully concerned that the lucky streak could end and put the firm into dire straits. If the divisional projects were deemed to be of similar risk, using the weighted- average cost of capital (WACC) would be justified. Oceanics divisions are basically connected with ship repair and installation service and seem to be involved in projects of similar risk. The WACC would therefore be okay to use. 2. How should Stephanie go about figuring out the cost of debt? Calculate the firms cost of debt.

COST OF DEBT Face Value n Price 10% Coupon( semiannual) YTM (annualized) Tax Rate After-tax Cost of Debt (annualized)

$1000 25x2 $915 $50 11.00% 34% 7.263%

*Ignoring flotation costs 3. Comment on Stephanies assumptions as stated in the case. How realistic are they? Here are the assumptions that Stephanie made and comments about their realism:

1. 2.

3. 4. 5. 6.

New debt would cost about the same as the yield on outstanding debt and would have the same rating. Very likely if the ratings havent changed. The firm would continue raising capital for future projects by using the same target proportions as determined by the book values of debt and equity Although in reality firms dont stick to the exact historical proportions of debt and equity, it can be argued that failure to do so would lead to higher future costs. However, its probably better to use current market value weights rather than book value proportions since prices of these securities and hence their weights have changed significantly. The equity beta (1.5) would be the same for all the divisions. This seems quite realistic given the nature of business of the divisions. The growth rates of earnings and dividends would continue at their historical rate quite realistic. The corporate tax rate would be 34% - seems logical. The flotation cost for debt would be 5% of the issue price and that for equity would be 10% of selling price these can be figured out quite accurately by talking to investment bankers.

4. Why there is a cost associated with a firms retained earnings? Retained earnings represent undistributed earnings. Since these earnings belong to shareholders, who could invest them in similar risk investments, it stands to reason that if a firm chooses not to distribute them as dividends, it should earn a rate of return on these earnings that is commensurate with what shareholders can earn in the market. Hence retained earnings have an opportunity cost for shareholders. 5. How can Stephanie estimate the firms cost of retained earnings? Should it be adjusted for taxes? Please explain. Stephanie can use the Dividend Growth Model and/or the Security Market Line (SML) approach to estimate the firms cost of retained earnings. Dividend Growth Model Approach RE D0 gm Po RE R*E = = = = = = D1/Po + gm = Dividend Yield + Growth Rate $0.25 (see Table 2 in the case) Constant growth rate = 16.5% $35 (0.25*(1+0.165) /$35) + 0.165 = 17.33% [0.25*(1+0.165) /$35*(1-0.10)] + 0.165 = 17.43%

SML Approach RE = = Rf + BE [E(RM - Rf)] 4.0% + 1.5(10% - 4%) = 13.04%

The cost of equity does not have to be adjusted for taxes because the return earned by common stockholders is based on the firms net income, which is an after-tax item. 6. Calculate the firms average cost of retained earnings. Average Cost of Retained Earnings = (17.33% + 13.4%)/2 = 15.166% 7. Can flotation costs be ignored in the analysis? Explain. Flotation costs can be ignored in calculating the weighted average cost of capital. However, when analyzing the Net Present Value of projects, the weighted flotation cost must be accounted for before a decision is made. For example, Lets say theres a project, which has an initial cost of $1,000,000 and no retained earnings available. Weighted average flotation cost = Weight of debt*Flotation cost of debt + Weight of equity * Flotation cost of new equity Component Price Debt $915 Equity $35 Total MV of Capital # outstanding 40,000 5,000,000 Market Value 36,600,000 175,000,000 211,600.000 Weight ____ 17.297% 82.71% 100%

Total Flotation Cost= 17.29% 5% + 82.71% 10% = 9.135% (see above) Since the project costs 1,000,000 without flotation costs, the cost after including flotation costs would be 1,000,000/(1-.09135) = $1,100,533.75 assuming there are no retained earnings available. 8. How should Stephanie calculate the firms hurdle rate? Calculate it and explain the various steps. Stephanie should first calculate the market value weights of the firms debt and equity components. The hurdle rate can then be calculated by computing the weighted average of the various component costs as follows: Component Price # outstanding Market Value Weight Cost (%) Weighted cost Debt $915 40,000 $36,600,000 17.30% 7.263% 1.256% Equity $35 5,000,000 $175,000,000 82.70% 15.166% 12.542% $211,600,000 100.00% 13.799% Thus the hurdle rate that can be used to discount the cash flows of future projects is 13.80%.

9. Can Larry assume that the hurdle rate calculated by Stephanie would remain constant? Please explain. No, Larry cannot assume that the hurdle rate calculated by Stephanie would remain constant because as the debt level increases, it is very likely that the firms ratings could change and investors would demand higher rates to buy its securities. Furthermore, the cost of equity could change as well if the firms beta changes.