Cost of Retained Earnings

Determining the Cost of Capital (WACC)
Case 19

Can One Size Fit All?
The Oceanic Corporation, a Chesapeake, VA based company,
was established in 1994. Glenn Rodgers III founded the corporation,
which was privately owned at the time, after his retirement from
Norentech Corporation.The Oceanic Corporation was originally formed 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 The Oceanic included
Habitability Installation, Industrial Contracting, andAlteration/ Installation Teams (AIT). With its initial success and goodreturn on investment the firm opened and operated facilities in California,New Jersey, Florida, Maryland, Pennsylvania and Washington.
In 1998, 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 $35 per share. There were currently 5 million shares outstanding. In 1999, the company issued 30year
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 91.5 % of
par.
Over the past year, The Oceanic Corporation utilized a new
method for fabricating composite materials that the firm's engineers 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 Larry Stone, a senior engineer, to head the
AM Group. Larry also had an MBA from a prestigious university under
his belt.
Upon joining Oceanic, Larry 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 Larry to his assistant Stephanie, "we can't possibly be this lucky
forever. We need to calculate the firm's hurdle rate and use it in future."
Stephanie Phillips, who had great admiration for her boss, replied, "Yes,
Larry, why don't I crunch out the numbers and give them to you within
the next couple of days?" "That sounds great, Stephanie," said Larry. "My years of experience tell me that when it comes to the hurdle rate for new projects, one size hardly ever fits all!"
As Stephanie 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 .5) 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 34%, and finally,
she assumed that the flotation cost for debt would be 5% of the issue
price and that for equity would be 10% of selling price. The 1year
Treasury bill yield was 4% and the expected rate of return on the market
portfolio was 10%.

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