Question

Your mini-case report should show and explain your calculations of component costs of capital, capital structure weights and WACC for Sea Shore Salt.

It should address the following questions:

1. What if Mr. Brinepool’s cost of equity was wrong?

2.Was there some other way to estimate the cost of equity as a check on the CAPM calculation?

3. Could there be other errors in his calculations, i.e. costs of debt, cost of preferred stock, capital structure weights?

For every step of your calculations, justify why all the component cost and component weight estimates used in your approach are correct.

MINICASE DETAILS: 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, 2016. The first 2 weeks went smoothly. Then Mr. Brinepool’s cost of capital memo (see Figure 13.2) 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 13.6. 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 for only $70 per share.

Figure 12-2 MEMO START

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.

END MEMO

table 13.6

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

• The common stock traded for $40 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:

Sustainable growth rate = 4/30 x .5 = 0.067 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%, and a market risk premium of 7%,

CAPM cost of equity = 7% +.5(7%)=10.5%

This cost of equity was significantly less than the 16% decreed in Mr. Brinepool’s memo.

Answer 1

1.Cost of Equity: If the cost of equity calculated by Brinepool is wrong, the WACC will be much lower.CAPM cost of Equity =10.7%.

WACC should be :

WACC= 8(1 – .35)(.20) + 7.75(1 – .35)(.133) + 6(.167) + 10.7(.50) = 8.06%

2. We can also fid the cost of equity by Dividend Discount Model(DDM)

Share Price =P0=$40

Next year dividend per share =D1=$2

Dividend growth rate=g=6.7%=0.067

Cost of Equity =Required Return =(D1/P0)+g=(2/40)+0.067=0.117=11.7%

This is 1% higher than Cost of equity as per CAPM

3.There is error in cost of preferred stock

Dividend per share =$6

Market value per share =$70

Cost of preference shares=6/70=8.57%

There is also error in weights:

Weights should be as per market value

Market Value of Bank Loan =$120

Long Term Debt =$80

Preferred stock=$70

Common Stock=$40*10=$400

Total Market Value of capital=(120+80+70+400)=670

Weight of Bank Loan=120/670=0.1791

Weight of Long term debt=80/670=0.1194

Weight of Preferred stock=70/670=0.1045

Weight of Common stock=400/670=0.5970

WACC=8(1 – .35)(0.1791)+ 7.75(1 – .35)(.1194) + 8.57(.1045) + 11.7(0.5970)=9.41%

The correct hurdle rate should be =9.41%