Question

The Midland Corporation (MC) was established in 1994. Glenn Jones founded the corporation, which was privately owned at the time.

MC was originally formed 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-lock work, as well as custom sheet metal fabrication. Other divisions of MC included Habitability Installation, Industrial Contracting, and Alteration/Installation Teams (AIT).

In 1998, 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 $30 per share. There were currently five million shares outstanding. In 1999, the company issued 30-year annual bonds at par, with a face value of $1,000 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 92.5% of par.

Over the past year, MC utilized a new method for fabricating composite materials that the firm’s engineers 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 Barry Rock, a senior engineer, to head the AM Group. Barry also had an MBA from a prestigious university under his belt.

Upon joining MC, Barry 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.

Barry stopped into your cubicle and said, “This has to change. We can’t possibly be this lucky forever. We need to calculate the firm’s hurdle rate.” Having recently joined the company after graduating from Northwood University, you jump at the opportunity to assist. “Great, we are receiving bids for a new project in two weeks, have a report on my desk by then” Barry said.

You begin your project by researching and gathering your data. You contact the Finance Department and they indicate the company has maintained its bond rating since it issued debt and ironically the yield on new debt the same as it was then. The Finance Department also tells you that the 1-year Treasury bill yield is 4%, the expected return on the market is 10%, and MC’s beta is 1.5. You then contact the Accounting Department and they tell you that MC’s corporate tax rate is 34% and that they don’t see any reason dividends won’t continue to grow at the same rate they have the past six to seven years. They also provide you with the copy of the most recent balance sheet and a summary of the company’s sales, EPS, and DPS for the last seven years (see Table 1& 2). You decide to use the existing capital structure using market values instead of book values (do not include current liabilities in this calculation).

Table 1

Balance Sheet (‘000s)
Cash	$5,000	Accounts Payable	$8,000
Accounts Receivable	10,000	Accruals	5,000
Inventory	20,000	Notes Payable	10,000
Total Current Assets	35,000	Total Current Liabilities	23,000
Land & Buildings (net)	43,000	Long-term Debt	40,000
Plant & Equipment (net)	45,000	Common Stock (5m shares)	50,000
Total Fixed Assets	88,000	Retained Earnings	10,000
Total Assets	$123,000	Total Liabilities and Equity	$123,000

Table 2

Sales, Earnings, and Dividend History
Year	Sales	Earnings Per Share	Dividends Per Share
1998	$24,000,000	$0.48	$0.10
1999	28,800,000	0.58	0.12
2000	36,000,000	0.72	0.15
2001	45,000,000	0.86	0.18
2002	51,750,000	0.96	0.20
2003	62,100,000	1.06	0.22
2004	74,520,000	1.20	0.25

Once you got back to your desk you had an email from Barry asking you several questions to make sure are covered in your report:

1. Why do you think we need to estimate the firm’s hurdle rate and how can we use it to our advantage? Is it justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital? Be sure to provide a thorough explanation.
2. What did you determine the firm’s cost of debt to be? Can you walk me through how you calculated it?
3. Will you explain to me why there is a cost associated with our retained earnings? Isn’t this our money?
4. I’m not sure which approach we should use to calculate the firm’s cost of retained earnings, will you use two of them (hint: CAPM and DCF) and take the average of them? Can you explain to me how you determined each of these? Do we need to make an adjustment for taxes?
5. I heard Jim Cramer talk about “Flotation Costs”, what are they? How are they going to impact our analysis?
6. What did you determine our WACC to be? Will you explain to me the steps so I can present it to our Board?
7. Can we safely assume that the hurdle rate will remain constant? Please explain and if not, how often should we adjust our analysis?

Answer 1

1. Hurdle rate will help the company to take loss-making or low margin projects. if for example cost of capital is 10% and company wants to maintain its margin of 5% then company will set its hurdle rate of 15% returns at least.

No, firm's overall cost of capital can't be taken as the divisional cost of capital, as some divisions might be riskier than the others,

2. here we to calculate the cost of debt

we know at maturity bond will expire at par value which is = 100

present value = 92.5

number of years left to maturity = 25

coupon rate = 10%

put the values in calculator and find I/Y

put as

PV = -92.5, FV = 100, n =25, PMT = 10, CPT I/Y

which you will get = 10.88%

adjusting to taxes = cost of debt ( 1- tax rate)

= 10.88% (1-0.34)

7.18%

3. Two possibilities are there

First Case : The company has outstanding debt for which company has a liability to pay coupon every year and principal amount when due. if in case company is not able to generate enough cash flows then these reatined earing will has to be used.

Second Case : if there is any off balance sheet item then that has to be taken care by retained earnings.

otherwise generally retained earnings belong to shareholders only.

4. cost of retained earnings or cost of equity can be calculated by CAPM and DCF both. by DCF we will get the IRR which is the minimum required return from a project and by CAPM we will get the cost to raise equity cappital and average of these two will give us better understanding. though we need terminal value to calculate cost of equity from DCF method.

Caculation By using CAPM

cost of equity = r(f) + beta * { r(market) - r(f)}

put the values cost of equity = 4% + 1.5 * { 10% - 4% } = 13%

By usnig DCF :

Present value of sum of cash out flow = present value of sum of cash inflows.

by using the above we can calcute the IRR.

no we dont need to make any adjustment for taxes as cost of equity is not affected by taxes.