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Case: "Determining the Cost of Capital"

Given the attached case study and balance sheet information, please answer the below exam review questions:

Oceantech Corporation, a Chesapeake, VA based company, was incorporated in 1991. The corporation, which was privately owned at that time, was founded by Ralph Torrence, III after his retirement from NorshipCo. Oceantech was originally designed to provide ship repair services and quickly earned a Department of Defense (DOD) certified Alteration Boat Repair (ABR) designation. Among its specialties were structural welding, piping system installation and repairs, electrical, painting, rigging, machinery and dry-dock work, as well as custom sheet metal fabrication. Other divisions of Oceantech included, Habitability Installation, Industrial Contracting, and Alteration/Installation Teams (All'). With its initial success and good return on investment the firm opened and operated facilities in California, New Jersey, Florida, Maryland, Pennsylvania and Washington.

In 1995, the company went public and its initial public offering was very successful. The stock price had risen from its initial value of $10 to its current level of $25 per share. There were currently 5 million shares outstanding. In 1997, the company issued 30-year bonds at par, with a face value of $1000 and a coupon rate of 10% per year, and managed to raise $40 million for expansion. Currently, the AA-rated bonds had 25 years left until maturity and were being quoted at 97.5% of par.

Over the past year, Oceantech utilized a new method for fabricating composite materials that the firm had developed. In June of last year, management established the Advanced Materials Group (AM Group), which was dedicated to pursuing this technology. The firm recruited Howard Sloan, a senior engineer, to head the AM Group. Howard also had an MBA from a prestigious university under his belt.

Upon joining Oceantech, Howard realized that most projects were being approved on a "gut feel" approach. There were no formal acceptance criteria in place. Up until then, the company had been lucky in that most of its projects had been well selected and it had benefited from good relationships with clients and suppliers. "This has to change," said Howard to his assistant Roseanne, "we can't possibly be this lucky forever. We need to calculate the firm's hurdle rate and use it in future." Roseanne Keane, who had great admiration for her boss replied, "Yes, Howard, why don't I crunch out the numbers and give them to you within the next couple of days?" " That sounds great, Roseanne," said Howard, "This should have been done a long time ago, but as most things go it's better late than never!"

As Roseanne began looking at the financial statements, she realized that she was going to have to make some assumptions. First, she assumed that new debt would cost about the same as the yield on outstanding debt and would have the same rating. Second, she assumed that 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 (see Table 1 for recent balance sheet). Third, she assumed that the equity beta (1.2) would be the same for all the divisions. Fourth, she assumed that the growth rates of earnings and dividends would continue at their historical rate (see Table 2 for earnings and dividend history). Fifth, she assumed that the corporate tax rate would be 40%, and finally, she assumed that the floatation cost for debt would be 10% of the issue price and that for equity would be 15% of selling price. The 1-year Treasury bill yield was 5% and the expected rate of return on the market portfolio was 12%.

The Balance Sheet for Oceantech Corp is as follows:
(Data in attached file)
The Sales, Earnings and Dividend history for Oceantech Corp is as follows:

Sales, Earnings and Dividend history ('000s)
(Data in attached file)
Questions
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.

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

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

4. Why is there a cost associated with a firm's retained earnings?

5. How can Roseanre estimate the firm's cost of retained earnings? Should it be adjusted for taxes? Please explain?

6. Calculate the firm's average cost of retained earnings.

7. Can flotation costs be ignored in the analysis? Explain.

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

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

Attachments

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See attached file for complete answers.

Questions:

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.

The firm must earn a minimum of rate of return in order to cover the cost of generating funds to finance investments. If this is not the case then no one will be willing to buy the firm's bonds, preferred stock, and common stock. The firm's required rate of return, is called the COST OF CAPITAL. or the hurdle rate. The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. This is why Howard Sloan wants to estimate the firm's hurdle rate

When there are differences in the degree of risk between the firm and its divisions then it is not justifiable to use the firm's weighted average cost of capital as the divisional cost of capital.

We use the company's cost of capital to value new assets which have the same risk as the old ones. If the company is acquiring new assets whose risk is more or less than the risk of the existing assets then the capital required to finance(fund) the new assets will have a different cost of capital as investors demand a return based on the risk to their investment.

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

From the case:
In 1997, the company issued 30-year bonds at par, with a face value of $1000 and a coupon rate of 10% per year, and managed to raise $40 million for expansion. Currently, the AA-rated bonds had 25 years left until maturity and were being quoted at 97.5% of par.
floatation cost for debt would be 10% of the issue price
New debt would cost about the same as the yield on outstanding debt and would have the same rating.

We use the effective annual rate of debt based on current market conditions (i.e. yield to maturity on debt). We do not use historical rates

For the issuing firm, the cost of debt is:
the rate of return required by investors,
adjusted for flotation costs (any costs associated with issuing new bonds), and
adjusted for taxes.

Face value= $1,000
coupon rate = 10% per year
Therefore annual interest= $100 =10%*1000
Current market price= 97.50% of par = $975 =97.5%*1000
Floatation cost= 10% of issue price
Therefore the company would get 90.00% of the issue price= $877.50 =90.%*975

Therefore yield= 11.40% =100/877.5

A more rigorous analysis would give the yield to maturity of 11.5% (see below)
but we will work with ...

Solution Summary

The solution discusses Case: "Determining the Cost of Capital" -Better Late Than Never.

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