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WACC Corrections- Case study-Sea Shore Salt

Bernice Mountaindog was glad to be back at Sea Shore Salt. Employees were treated well. When she had asked a year ago for a leave of absence to complete her degree in finance, top management promptly agreed. When she returned with an honors degree, she was promoted from administrative assistant (she had been secretary to Joe-Bob Brinepool, the president) to treasury analyst. Bernice thought the company's prospects were good. Sure, table salt was a mature business, but Sea Shore Salt had grown steadily at the expense of its less well-known competitors. The company's brand name was an important advantage, despite the difficulty most customers had in pronouncing it rapidly. Bernice started work on January 2, 2003. The first two weeks went smoothly. Then Mr. Brinepool's cost of capital memo (see Figure 12-2) assigned her to explain Sea Shore Salt's weighted average cost of capital to other managers. The memo came as a surprise to Bernice, so she stayed late to prepare for the questions that would surely come the next day. Bernice first examined Sea Shore Salt's most recent balance sheet, summarized in Table 12-5. Then she jotted down the following additional points:

? The company's bank charged interest at current market rates, and the long-term debt had just been issued. Book and market values could not differ by much.
? But the preferred stock had been issued 35 years ago, when interest rates were much lower. The preferred stock was now trading for only $70 per share.
? The common stock traded for $40 per share. Next year's earnings per share would be about $4.00 and dividends per share probably $2.00. Sea Shore Salt had traditionally paid out 50 percent of earnings as dividends and plowed back the rest.
? Earnings and dividends had grown steadily at 6 to 7 percent per year, in line with the company's sustainable growth rate:

Sustainable = return × plowback

growth rate on equity ratio = 4.00/30 × .5 = .067, or 6.7%

? Sea Shore Salt's beta had averaged about .5, which made sense, Bernice thought, for a stable, steady-growth business.
She made a quick cost of equity calculation by using the capital asset pricing model (CAPM). With current interest rates of about 7 percent, and a market risk premium of 8 percent, CAPM cost of equity = rE = rf + β(rm - rf)
= 7% + .5(8%) = 11%

This cost of equity was significantly less than the 16 percent decreed in Mr. Brinepool's memo. Bernice scanned her notes apprehensively. What if Mr. Brinepool's cost of equity was wrong? Was there some other way to estimate the cost of equity as a check on the CAPM calculation? Could there be other errors in his calculations?

Bernice resolved to complete her analysis that night. If necessary, she would try to speak with Mr. Brinepool when he arrived at his office the next morning. Her job was not just finding the right number. She also had to figure out how to explain it all to Mr. Brinepool.

Salt's balance sheet, taken from the company's 2002 balance sheet (figures in millions)

Assets

Working capital $200

Plant and Equip 360

Other Assets 40

Total $600

Liabilities and Net Worth

Bank loan $120

Long-term debt 80

Preferred stock 100

Common stock, including retained earnings 300
Total $600

Figure 12-2

DATE: January 15, 2003

TO: S.S.S. Management

FROM: Joe-Bob Brinepool, President
SUBJECT: Cost of Capital

This memo states and clarifies our company's long-standing policy regarding hurdle rates for capital investment decisions. There have been many recent questions, and some evident confusion, on this matter. Sea Shore Salt evaluates replacement and expansion investments by discounted cash flow. The discount or hurdle rate is the company's after-tax weighted-average cost of capital.

The weighted-average cost of capital is simply a blend of the rates of return expected by investors in our company. These investors include banks, bond holders, and preferred stock investors in addition to common stockholders. Of course many of you are, or soon will be, stockholders of our company. The following table summarizes the composition of Sea Shore Salt's financing.

Amount Percent Rate of Return
Bank Loan 120 20% 8%

Bond Issue 80 13.3% 7.75%
Pref. Stock 100 16.7% 6

Common Stock 300 50 16
Total 600 100%

The rates of return on the bank loan and bond issue are of course just the interest rates we pay. However, interest is tax-deductible, so the after-tax interest rates are lower than shown above. For example, the after-tax cost of our bank financing, given our 35% tax rate, is 8(1 - .35) = 5.2%. The rate of return on preferred stock is 6%. Sea Shore Salt pays a $6 dividend on each $100 preferred share.

Our target rate of return on equity has been 16% for many years. I know that some newcomers think this target is too high for the safe and mature salt business. But we must all aspire to superior profitability.
Once this background is absorbed, the calculation of Sea Shore Salt's weighted average cost of capital (WACC) is elementary:
WACC = 8(1 - .35)(.20) + 7.75(1 - .35)(.133) + 6(.167) + 16(.50) = 10.7%
The official corporate hurdle rate is therefore 10.7%.
If you have further questions about these calculations, please direct them to our new Treasury Analyst, Ms. Bernice Mountaindog. It is a pleasure to have Bernice back at Sea Shore Salt after a year's leave of absence to complete her degree in finance.

Solution Preview

See attached file

WACC corrections

Step 1
Calculate :
1 Cost of debt, common stock and preferred stock
2 Market value of debt, common stock and preferred stock

Debt

? The company's bank charged interest at current market rates, and the long-term debt had just been issued. Book and market values could not differ by much.

from Bernice's notes

the rates of return on the bank loan and bond issue are of course just the interest rates we pay. However, interest is tax-deductible, so the after-tax interest rates are lower than shown above. For example, the after-tax cost of our bank financing, given our 35% tax rate, is 8(1 - .35) = 5.2%.
from Mr. Brinepool's memo

The statements are correct

Current Mkt Value Pre tax cost After tax cost
Debt:
Bank loan 120 million 8% 5.2000%
Long-term debt 80 million 7.75% 5.0375%

Preferred stock:

The rate of return on preferred stock is 6%. Sea Shore Salt pays a $6 dividend on each $100 preferred share.

from Mr. Brinepool's memo

? But the preferred stock had been issued 35 years ago, when interest rates were much lower. The preferred stock was now trading for only $70 per share.

from Bernice's notes

Bernice is right
The cost cannot be 6%
It is higher. It is equal to 8.57% =6/70

The market value also cannot be 100
It is equal to (70/100)*100= 70

Current Mkt Value After tax ...

Solution Summary

The solution provides corrected value of Weighted Average Cost of Capital

$2.19