Case:15  “Determining the Cost of Capital”

Better Late Than Never

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:

                                                 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.