Question

Transformers Industry & Technology Inc. is a diversified industrial company. The Company owns businesses providing products & services to the energy, transportation, chemical, and construction sectors.

The energy segment operates as an oil and natural gas contract drilling company the United States. The energy segment acquires, explores, develops, and produces oil and natural gas properties primarily located in Oklahoma and Texas, as well as in Arkansas, Colorado, Kansas, Louisiana, Mississippi, Montana, New Mexico, North Dakota, Utah, and Wyoming. This segment generated over $10 billion of revenue in 2016.

The transportation segment is among the largest public railroad in North America. Operating on 12,000 miles of track in the western one thirds of the U.S., This segment generated over $20 billion of revenue in 2016 by hauling coal, industrial products, intermodal containers, agriculture goods, chemicals, and automotive goods.

The chemical segment sells value-added chemicals, thermoplastic polymers, and other chemical-based products worldwide. This segment develops, produces, and supplies specialty polymers for automotive and medical applications, as well as for use in industrial products and consumer electronics. This segment generated over $5 billion of revenue in 2016.

The Construction segment produces and sells specialty construction chemicals, specialty building materials, and packaging sealants and coatings. The Company operates through two segments: Specialty Construction Chemicals and Specialty Building Materials. The Specialty Construction Chemicals segment manufactures and markets products to manage performance of Portland cement, and materials based on Portland cement, such as concrete admixtures and cement additives, as well as concrete production management systems. The Specialty Building Materials segment manufactures and markets building envelope products, residential building products and specialty construction products. This segment generated over $5 billion of revenue in 2016.

During the last few years, Transformers Industry has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. The expansion requires investment in eight projects from the four segments. Table-1 provides information about the projects.

Assume that you are an assistant to Jim Jones, the financial vice president. Your first task is to estimate Transformers cost of capital.

As a part of your analysis you have collected the following data:

The firm's tax rate is 40%.

The current price of Transformers 12% coupon, semiannual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. TPIT does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Transformers would incur flotation costs equal to 5% of the proceeds on a new issue.

Transformers common stock is currently selling at $50 per share. Its last dividend was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the foreseeable future. Transformers beta is 1.2, the yield on T-bonds is 5.6%, and the market risk premium is estimated to be 6%.

Suppose the firm has historically earned 15% on equity (ROE) and retained 35% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5.8% growth rate given earlier?

Transformers target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

Suggested questions

1) What sources of capital should be included when you estimate Transformers weighted average cost of capital (WACC)?

2) Should the component costs be figured on a before-tax or an after-tax basis?

3) Should the costs be historical (embedded) costs or new (marginal) costs? Explain?

4) Transformers preferred stock is riskier to investors than its debt, yet the preferred yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

5) What is the market interest rate on Transformers debt and what is the component cost of this debt for WACC purposes?

6) What is the corporate cost of capital?

Part 2

1) Jim Jones was worried that whether the corporate cost of capital would be appropriate to evaluate the four segments’ project. His concern centered on whether the risk of the projects is reflected on the corporate cost of capital? What is the logical method of adjusting the cost of capital for risk? Is it wise to use the corporate cost of capital to evaluate the four segments’ projects?

2) Discuss the quantitative methods that are useful to evaluate the projects?

3) Discuss the strengths and weakness of each quantitative method you have selected to evaluate the projects?

4) Will all of the quantitative methods rank the projects identically? Why or why not?

5) Rank the projects on the basis of the measurements discussed above.

	Annual cash flows:		Annual cash flows:		Annual cash flows:		Annual cash flows:
	Energy		Transportation		Chemical		Construction
Year	EA	EB	TC	TD	CHE	CHF	ConG	ConF
0	($1,500,000)	($1,500,000)	$ (650,000)	($200,000)	($350,000)	($300,000)	($200,000)	($200,000)
1	$450,000	$440,000	$    210,000	$97,000	$144,000	$43,000	$88,500	$101,000
2	$650,000	$440,000	$    210,000	$97,000	$144,000	$98,000	$91,000	$78,000
3	$650,000	$440,000	$    210,000	$97,000	$144,000	$152,000	$88,000	$87,000
4	$440,000	$540,000	$    210,000	$97,000	$144,000	$168,000	$88,000	$87,000
5	$330,000	$540,000	$    210,000	$97,000	$144,000	$184,000	$88,000	$87,000
6	$250,000	$540,000	$    210,000	$97,000	$144,000	$200,000	$88,000	$87,000

Comparable Companies- Energy	Market Cap Mil	Net Income Mil	Interest Coverage	D/E	Equity Beta
Unit Corp	1,346	30	—	0.6	1.2
Omv AG (USD,EUR)	21,927	-151	-0.9	0.4	0.6
Omv AG (USD,EUR)	21,927	-151	-0.9	0.4	0.6
Helmerich & Payne Inc (USD)	7,725	-128	-8.3	0.1	0.4
RSP Permian Inc (USD)	6,553	92	0.2	0.4	0.5
Patterson-UTI Energy Inc (USD)	5,445	-267	-11.3	0.2	0.3
Transocean Ltd (USD)	4,538	-2,773	3.3	0.5	0.5
Ensco PLC (USD)	2,998	-57	5.4	0.6	0.8
Diamond Offshore Drilling Inc (USD)	2,693	166	-4.2	0.5	1
Ocean Rig UDW Inc (USD)	2,614	-3,809	-14.2	0.2	0.75
Nabors Industries Ltd (USD)	2,581	-766	-5.5	1.4	1.3
Rowan Companies PLC (USD)	2,009	-63	3.1	0.5	0.8
CES Energy Solutions Corp (USD,CAD)	1,325	29	-1.6	0.7	0.9
Noble Corp PLC (USD)	1,249	-1,794	-3.3	0.7	0.85
SONGA OFFSHORE SE (USD)	1,062	-40	0.6	2.3	1.5
Ensign Energy Services Inc (USD,CAD)	957	-146	-5.6	0.4	0.55
Sabine Royalty Trust (USD)	708	33	—	—	0.3
Trinidad Drilling Ltd (USD,CAD)	398	-73	-0.8	0.4	0.25
Seadrill Partners LLC (USD)	346	216	4.5	2.5	1.8
Pioneer Energy Services Corp (USD)	287	-98	-4.4	1.8	1.35
Archer Ltd (USD)	219	-2	-1.6	2.9	1.8
Fred Olsen Energy ASA (USD)	201	-185	-1.1	1	0.85
Fred Olsen Energy ASA (USD)	201	-185	-1.1	1	0.75
Independence Contract Drilling Inc (USD)	197	-28	-6.2	0.2	0.3
Pantheon Resources PLC (USD)	171	-1	—	—	0.5
Xtreme Drilling Corp (USD,CAD)	138	-82	-18	—	0.5
Industry Average	1,779	1	-522.2	0.6

Comparable Companies- Transportation	Market Cap Mil	Net Income Mil	Interest Coverage	D/E	Equity Beta
Union Pacific Corp	110,542	4,578	10.7	0.8	1.06
Canadian National Railway Co (USD,CAD)	60,016	3,891	11.3	0.6	0.85
CSX Corp (USD)	51,880	1,789	5.7	1.1	1.33
Norfolk Southern Corp (USD)	43,898	1,852	5.6	0.7	1.54
East Japan Railway Co (USD,JPY)	39,937	291,733	6.8	0.9	0.9
Central Japan Railway Co (USD,JPY)	37,319	398,785	10.3	1.5	0.43
Canadian Pacific Railway Ltd (USD,CAD)	26,283	1,805	5.6	1.3	1.14
Kansas City Southern (USD)	11,545	539	7.8	0.5	0.73
Westinghouse Air Brake Technologies Corp (USD)	7,856	251	—	0.7	0.92
Guangshen Railway Co Ltd (USD,CNY)	5,652	952	—	—	1.37
Industry Average	13,429	29,956	15.9	0.8

Comparable Companies- Chemical	Market Cap Mil	Net Income Mil	Interest Coverage	D/E	Equity Beta
Eastman Chemical Co	13,917	1,009	4.7	1.3	1.21
A. Schulman Inc (USD)	1,128	44	1.6	4.2	1.84
Asahi Kasei Corp (USD,JPY)	18,510	132,954	36.5	0.2	0.3
Ashland Global Holdings Inc (USD)	4,540	1	0.6	0.8	1.31
Balchem Corp (USD)	2,583	64	12.4	0.4	0.5
Basf SE (USD,EUR)	108,362	5,230	9.2	0.4	1.03
Bio-En Holdings Corp (USD)	129	0	-27.9	—	-0.63
BioAmber Inc (USD)	23	-24	-8.8	0.2	3.16
Industry Average	11,925	29,851	125.4	0.5	1.09

	Market Cap Mil	Net Income Mil	Interest Coverage	D/E	Equity Beta
Vulcan Materials Co	17,862	386	5.1	0.6	0.91
Daikin Industries Ltd (USD,JPY)	36,579	159,019	24.3	0.3	0.83
Compagnie de Saint-Gobain SA (USD,EUR)	32,398	1,311	5.7	0.4	0.39
CRH PLC (USD,EUR)	30,435	1,327	6.2	0.6	0.96
Masco Corp (USD)	14,438	544	4.6	—	1.45
Martin Marietta Materials Inc (USD)	14,267	435	8.4	0.4	1.32
Cemex SAB de CV (USD,MXN)	11,943	21,512	1.8	1.1	1.35
Owens-Corning Inc (USD)	10,682	379	—	0.6	0.73
Asahi Glass Co Ltd (USD,JPY)	10,275	75,138	10.1	0.3	0.5
James Hardie Industries PLC (USD)	9,465	256	13.9	—	1.4
Industry Average	18834.4	26030.7	8.9	0.5375

Answer 1

ROE= 15%

Retained Earnings= 35%

Sustainable Growth Rate= 0.15x 0.35

= 5.25%

Compared to 5.8%

1) The sources of capital that should be included to estimate Transformers weighted average cost of capital (WACC) are-

• Debt (Bond)

• Preferred Stock (Perpetual)

• Common Stock

2) The component costs be figured on the following basis-

• Debt- After Tax (Since interest is Tax deductible)

• Preferred Stock- Before Tax

• Common Stock- Before Tax

3) The costs should be new (marginal) costs based on the target weights of the sources of capital of the firm. This is because cost of capital is important for taking decision on certain projects and thus the targeted capital structure is important. In the long run, companies should adhere to target weights for each of the sources of funding.

4) Transformers preferred stock is riskier to investors than its debt, yet the preferred yield to investors (9.0%) is lower than the yield to maturity on the debt (10%). The statement is true but the cost of debt is tax deductible and the after tax cost of debt is 6%, which is much less than cost of preferred stock.

Cost of preferred Stock

Dividend per share= 0.1x 100= $10

Cost of Preferred Stock= 10/ [116.95x(1-0.05)]= 9.0%

5) The YTM for the bonds are calculated as follows-

60/ [(1+y)^1]   +   60/ [(1+y)^2]   +…+ 1060/ [(1+y)^30]= 1153.72

Solving for y, y= 0.05= 5%

So, YTM= 10%

So, the market interest rate on Transformers debt= 10%

The component cost of this debt for WACC purposes= 10x (1-tax rate)

= 10x (1-0.4)

= 6%

PART 2

1) The logical method of adjusting the cost of capital for risk is through beta, where we take higher beta for high risk projects. When the four segment projects have different risks, it’s not proper to use corporate cost of capital for evaluating the projects. We should determine cost of capital separately for each of the projects by changing the beta for the projects as per the risk.

2) The conventional quantitative methods that are useful to select/ reject the projects are

NPV Method

IRR Method

Payback Period

3) NPV Method Strengths

• Net present value accounts for time value of money

• NPV is even better than some other discounted cash flows techniques such as IRR. In situations where IRR and NPV give conflicting decisions, NPV decision should be preferred

NPV Method Weaknesses

• NPV is an estimation. It is sensitive to changes in estimates for future cash flows, salvage value and the cost of capital.

• Net present value does not take into account the size of the project

IRR Method Strengths

• Accounts for time value of money

• Can be compared with the cost of capital of firm I.e. the required rate of return

IRR Method Weaknesses

• Multiple IRR problem occurs when cash flows during the project lifetime is negative other than the initial investment. This is called non conventional cash flow

• Does not take into account the size of the project

• Sensitive to changes in estimates such as future cash flows, salvage value

4) NPV and IRR methods may produce different results and rank projects differently and in case of such conflicting decisions NPV may be preferred over IRR. If these projects are independent, it wouldn’t matter much because the firm can accept all the projects. However, in case of mutually exclusive projects, the firm needs to decide one and NPV method is accepted in that case.