Question

FINAN 3040: WACC Assignment

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, 2018. The first 2 weeks went smoothly. Then Mr. Brinepool’s cost of capital memo (see Figure 1) assigned her to explain Sea Shore Salt’s weighted-average cost of capital to other mangers. 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 1. 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, originally issued at a book value of $100 per share, was now trading at only $80 per share.

· The common stock traded for $50 per share. Next year’s earnings per share would be about $4 and dividends per share probably $2. (Ten million shares of common stock are outstanding.) Sea Shore Salt had traditionally paid out 50% of earnings as dividends and plowed back the rest.

· Earnings and dividends had grown steadily at 6% to 7% per year, in line with the company’s sustainable growth rate:

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 risk-free interest rates of about 3%, and a market risk premium of 12.6%, this gives...9.3%

This cost of equity was significantly less than the 14% 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.

Figure 1: Mr. Brinepool’s Cost of Capital Memo

Sea Shore Salt Company

Spring Vacation Beach, Florida

CONFIDENTIAL MEMORANDUM

DATE: January, 15, 2018

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, bondholders, 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 (in millions)	Percent of Total	Rate of Return
Bank loan	$120	20.0%	5.00%
Bond issue	80	13.3	5.25
Preferred stock	100	16.7	7.00
Common stock	300	50.0	14.00
	$600	100.0%

The rates of return on the bank loan and the 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 21% tax rate, is 5(1 – .21) = 3.95%

The rate of return on preferred stock is 7%. Sea Shore Salt pays a $7 dividend on each $100 preferred share.

Our target rate of return on equity has been 14% 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 = 5(1 – .21)(.20) + 5.25(1 – .21)(.133) + 7(.167) + 14(.50) = 9.51%

The official corporate hurdle rate is therefore 9.51%.

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.

Table 1: 2017 Balance Sheet

Sea Shore Salt’s balance sheet, taken from the company’s 2017 balance sheet (figures in $millions)

Assets			Liabilities and Net Worth
Working capital	$200		Bank loan	$120
Plant and equipment	360		Long-term debt	80
Other assets	40		Preferred stock	100
			Common stock, including retained earnings	300
Total	$600		Total	$600

Notes:

1. At year-end 2017, Sea Shore Salt had 10 million common shares outstanding.

2. The company had also issued 1 million preferred shares with book value of $100 per share. Each share receives an annual dividend of $7.

Chapter 13 Assignment

Calculate the following. You will be graded as follows:

1. Cost of equity using dividend discount model: 3 points

2. Cost of preferred stock: 3 points

3. Cost of debt. Include both sources of debt. 2 points

4. The weight of each component (% of each). 4 points

5. WACC calculation. 5 points

6. Briefly discuss the difference in your calculation and 3 points

the boss’ calculation. Where did he go wrong?            

Answer 1

1	Cost of Equity by Dividend discount model;
	Assuming average growth rate in Dividend is 6.5%=g
	(average of 6% and 7% given)
	Common share price =$50/share =P0
	Next year dividend =D1=$2 /share
	As per the formula of Dividend discount model
	P0=D1/(k-g)
	where k=cost of Equity
	so, 50=2/(k-6.5%)
	Or k=10.5%
	so Cost of Equity by dividend discount model=10.5%

2	Market Price of Preferred stock=$80/share
	Annual dividend /pref share=$7
	Cost of Preferred share =7/80=8.75%

3	Cost of Bank Loan=5%.
	Tax Rate =21%
	Post Tax cost of Bank loan =5%*(1-21%)=3.95%
	Cost of Bond =5.25%
	Post tax cost of bond =5.25%*(1-21%)=4.15%

				Ans 4		Ans 5
Weight of components and WACC
Type of Capital	Outstanding no of shares	Market Value /share	Total Market Value	Weight if Capital Component based on Market Value	Post Tax Cost	Weighted post tax cost
Equity	10,000,000	50	500,000,000	64.1%	10.50%	6.73%
Preference share	1,000,000	80	80,000,000	10.3%	8.75%	0.90%
Bank Loan			120,000,000	15.4%	3.95%	0.61%
Bond			80,000,000	10.3%	4.15%	0.43%
Total			780,000,000			8.66%

So WACC =8.66%

Ans 6.

The boss's calculation went wrong in thee areas;

1. The weight of the components to be taken on the

basis of their market values, not on book values

2. Cost of equity of 14% was too high and 9.3% as

per CAPM was too optimistic. It can be derived by

dividend discount model , which comes to 10.5%

based on future divdend earnings and more reasonable.

3. The preference share cost calculation needs to be

on the basis of present markte value, which come to

8.75% not 7%.

As a result of the above changes in assumptions ,

the revised WACC comes to 8.66%.