Case 15: Better Late Than Never

Case 15:Better Late Than Never Case Discussion

Objectives • Learn how to estimate a firm’s average cost of capital • Analyze the impact of floatation costs and target weights on a firm’s cost of capital

Background • Howard Sloan, recently hired as head of the Advanced Materials Group of Oceantech Corporation. • He is concerned that most projects were being approved on a “gut feel” approach. • No formal acceptance criteria in place. • Asks his assistant, Roseanne Keane, to calculate the firm’s hurdle rate for future use.

Question 1 • Why do you think Howard Sloan wants to estimate the firm’s hurdle rate? • Is it justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital? • Please explain.

Answer 1 • Howard wants a yardstick with which to measure the feasibility of future investment proposals. • Thus far, using a ‘gut feel’ approach… • Howard was rightfully concerned that the lucky streak could end and…. put the firm into dire straits.

Answer 1 (Continued) • If the divisional projects are deemed to be of similar risk, using the weighted average cost of capital (WACC)would be justified. • Oceantech’s 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.

Question 2 • How should Roseanne go about figuring out the cost of debt? • Calculate the firm’s cost of debt.

Answer 2 COST OF DEBT* Face Value $1000 Maturity 25 years Price $975 Coupon $50 YTM 10.28% Tax Rate 40% After-tax Cost of Debt 6.17% = 10.28(1-.4) *Ignoring floatation costs

Question 3 Comment on Roseanne’s assumptions as stated in the case. How realistic are they?

Answer 3 • Here are the assumptions that Roseanne made and comments about their realism: 1.New debt would cost about the same as the yield on outstanding debt and would have the same rating. – Very likely if the ratings haven’t changed. 2. 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 don’t 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. It’s probably better to use current market value weights rather than book value proportions, however. Since prices of these securities and hence their weights have changed significantly.

Answer 3 (Continued) 3. The equity beta (1.2) would be the same for all the divisions. This seems quite realistic given the nature of business of the divisions. 3.4. The growth rates of earnings and dividends would continue at their historical rate – quite realistic. 4. 5. The corporate tax rate would be 40% - seems logical. 6 . 6. The floatation cost for debt would be 10% of the issue price and that for equity would be 15% of selling price – these can be figured out quite accurately by talking to investment bankers.

Question 4 • Why is there a cost associated with a firm’s retained earnings?

Answer 4 • 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.

Question 5 • How can Roseanne estimate the firm’s cost of retained earnings? • Should it be adjusted for taxes? • Please explain?

Answer 5 • Roseanne can use the Dividend Growth Model and/or the Security Market Line (SML) approach to estimate the firm’s cost of retained earnings. Dividend Growth Model Approach RE = D1/Po + g = (0.60*(1+.2078) /$25)+0.2078 = 0.23678 or 23.68% SML Approach RE = Rf + BE X [E(RM-Rf)] = 5% + 1.2(12% - 5%) = 13.4% Note: The cost of equity does not have to be adjusted for taxes because the return earned by common stockholders is based on the firm’s net income, which is an after-tax item.

Question 6 • Calculate the firm’s average cost of retained earnings.

Answer 6 • Average Cost of Retained Earnings • = (23.68% + 13.4%)/2 = 18.54%

Question 7 • Can floatation costs be ignored in the analysis? Explain.

Answer 7 • Floatation costs can be ignored in calculating the weighted average cost of capital. • However, when analyzing the Net Present Value of projects, the weighted floatation cost must be accounted for before a decision is arrived at. For example, Let’s say there’s a project which has an initial cost of $1,000,000 and no retained earnings available. Weighted average floatation cost = Weight of debt*Floatation cost of debt + Wt. of equity * Floatation cost of new equity = 24% * 10% + 76% * 15% = 13.8% (see above) Since the project costs 1,000,000 before floatation costs, the cost after including floatation costs would be 1,000,000/(1-.138) = $1,160,093 (assuming there are no retained earnings available)

Question 8 • How should Roseanne calculate the firm’s hurdle rate? • Calculate it and explain the various steps.

Answer 8 • Roseanne should first calculate the market value weights of the firm’s 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 Wt. Cost(%) Wtd. cost Debt $975 40,000 $39,000,000 24% 6.17% 1.48% Equity $25 5,000,000 $125,000,000 76% 18.54% 14.09% $164,000,00015.57% Thus the hurdle rate that can be used to discount the cash flows of future projects is 15.57%.

Question 9 • Can Howard assume that the hurdle rate calculated by Roseanne would remain constant? • Please explain.

Answer 9 • No, Howard cannot assume that the hurdle rate calculated by Roseanne would remain constant because as the debt levels increase… • it is very likely that the firm’s ratings could change and investors would demand higher rates to buy its securities. • Furthermore, the cost of equity could change as well, if the firm’s beta changes.

Case 15: Better Late Than Never