Case:15 ��Determining the
Cost of Capital�
Better Late Than Never
Oceantech Corporation, a
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:
����������������������������������������������� �Balance Sheet (�000s)
|
Cash |
5000 |
Accounts
Payable |
8,000 |
|
Accounts
Receivables |
10,000 |
Accruals |
5,000 |
|
Inventory |
20,000 |
Notes
Payable |
10,000 |
|
Total
Current Assests |
35,000 |
Total
Current Liabilities |
23,000 |
|
|
|
|
|
|
Land and
Buildings(net) |
43,000 |
Long term
Debt |
40,000 |
|
Plant
and equipment (net) |
45,000 |
Common
stock (5
million shares outstanding) |
50,000 |
|
Total
Fixed Assets |
88,000 |
Retained
Earnings |
10,000 |
|
|
|
|
|
|
Total
Assets |
123,000 |
Total
Liabilities and Shareholders equity |
123,000 |
The Sales,
Earnings and Dividend history for Oceantech Corp is
as follows:
����������������������������������� Sales,
Earnings and Dividend history (�000s)
|
Year |
Sales($) |
Earnings per share($) |
Dividends per share($) |
|
1995 |
24,000,000 |
0.48 |
0.19 |
|
1996 |
28,800,000 |
0.58 |
0.23 |
|
1997 |
36,000,000 |
0.72 |
0.29 |
|
1998 |
45,000,000 |
0.90 |
0.36 |
|
1999 |
51,750,000 |
1.04 |
0.41 |
|
2000 |
62,100,000 |
1.24 |
0.50 |
|
2001 |
74,520,000 |
1.49 |
0.60 |
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 floatation 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.