Can One Size Fit All?

CASE DESCRIPTION?

Why do you think Larry Stone 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.

Larry wants to estimate the firm’s hurdle rate because it would provide him with a yardstick with which to measure the feasibility of future investment proposals. The firm had thus far been using a ‘gut feel’ approach and although most of the decisions had turned out to be good ones,

If the divisional projects were deemed to be of similar risk, using the weighted- average cost of capital (WACC) would be justified. Oceanic’s divisions are basically connected with ship repair and installation service and seem to be involved in projects of similar risk. The WACC would therefore be okay to use.

Here are the assumptions that Stephanie made and comments about their realism:

  New debt would cost about the same as the yield on outstanding debt

and would have the same rating. – Very likely if the ratings haven’t changed.

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 –it’s probably better to use current market value weights rather than book value proportions since prices of these securities and hence their weights have changed significantly.

The equity beta (1.5) would be the same for all the divisions. This seems quite realistic given the nature of business of the divisions.

The growth rates of earnings and dividends would continue at their historical rate – quite realistic.

The corporate tax rate would be 34% - seems logical. The flotation cost for debt would be 5% of the issue price and that for

equity would be 10% of selling price – these can be figured out quite accurately by talking to investment bankers.

Why is there a cost associated with a firm’s retained earnings?

Why is there a cost associated with a firm’s retained earnings?

Retained earnings represent undistributed earnings. Since these earnings belong to shareholders, who could invest them in similar risk investments, it stands to reason that if a firm chooses not to distribute them as dividends, it should earn a rate of return on these earnings that is commensurate with what shareholders can earn in the market. Hence retained earnings have an opportunity cost for shareholders.

How can Stephanie estimate the firm’s cost of retained earnings? Should it be adjusted for taxes? Please explain.

COST OF RETAINED EARNING CAN BE TAKEN AS THE COST OF EQUITY

WHICH MIGHT BE ADJUSTED FOR PERSONAL TAXES OR BROKERAGE

How can Stephanie estimate the firm’s cost of retained earnings? Should it be adjusted for taxes?

Please explain.

Calculate the firm’s average cost of retained earnings

Table 2 The Oceanic Corporation Sales, Earnings, and Dividend History ('000s) Year Sales Earnings per Share Dividends per Share

Average Growth Rate 16.62%

How can Stephanie estimate the firm’s cost of retained earnings? Should it be adjusted for taxes? Please explain.

Stephanie can use the Dividend Growth Model and/or the Security Market Line (SML) approach to estimate the firm’s cost of retained earnings.

Dividend Growth Model Approach RE = D1/Po + gm = Dividend Yield + Growth Rate D0 = $0.25 (see Table 2 in the case) gm = Constant growth rate = 16.2% Po = $35 RE = (0.25*(1+0.162) /$35)+0.162 = 17.5%

SML Approach RE = Rf + BE X [E(RM-Rf)] = 4.4% + 1.5(10% - 4%) = 13.4%

Average Cost of Retained Earnings = (17.21% + 13.4%)/2 = 15.31%

Can flotation costs be ignored in the analysis? Explain.

when analyzing the Net Present Value of projects, the weighted flotation cost must be accounted for before a decision is made. For example,

  Let’s say there’s a project, which has an initial cost of $1,000,000 and no

retained earnings available.   Weighted average flotation cost = Weight of debt*Flotation cost of

debt + Wt. Of equity * Flotation cost of new equity   Component Price # outstanding Market Value Wt.____

Wt.____ Debt $915 40,000 36,600,000 17.297% Equity $35 5,000,000 175,000,000 82.71% Total MV of Capital 211,600.000 100%     Total Flotation Cost= 17.29% * 5% + 82.71% * 10% = 9.135%

How should Stephanie calculate the firm’s hurdle rate? Calculate it and explain the various steps.

 =(0.175*0.82)+(0.0726*0.172)=15.6%

Thus the hurdle rate that can be used to discount the cash flows of future projects is either of these two or average.

Can Larry assume that the hurdle rate calculated by Stephanie would remain constant? Please explain.

Can Larry assume that the hurdle rate calculated by Stephanie would remain constant? Please explain.

 No, Larry cannot assume that the hurdle rate

calculated by Stephanie would remain constant because as the debt level increases, it is very likely that the firm’s ratings could change and investors would demand higher rates to buy its securities. Furthermore, the cost of equity could change as well if the firm’s beta changes.