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 a honors degree, she was promoted form administrative assistant (she had been secretary to Joe-Bob Brinepool, the president) to treasury analyst.

Bernice thought the company's prospect 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, 2009. The first 2 weeks went smoothly. Then Mr. Brinepool's 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 stack had been issued 35 years ago, when interest rates were much lower. The preferred stock was now trading for only $70 per share.

---The common stock traded for $40 per share. Next year's earnings per share would be about $40 per share. Next year's earnings per share would be about $4 and dividends per share probably $2. Sea Shore Salt and 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 return plowback

Growth rate = on equity x ratio

= 4/30 x .5

= .067, or 6.7%

---Sea Shore Salt's beta had average aboutl .5, which made sense, Bernice thought, for the stable, steady-growth busness. She made a quick cost of equity calculation by using the capital asset pricing maodel (CAPM). With current interest rates of about 7%, and a market risk peemium of 7%.

CAPM cost of equity = re = rf to B(rm-rf)

= 7% + .5(7%) = 10.5%

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

Table 13-6 Sea Shore Salt's balance sheet, taken from the company's 2008 balance sheet (figures in millons) Notes: (1) At year end 2008, Sea Shore had 10 million 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 $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 300

Total $600 Total $600

Figure 13-2 Mr. Brinepool's cost of capital memo

Sea Shore Salt Company

Spring Vacation Beach, FL

Confidential Memorandum

Date: January 15, 2009

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% 8%

Bond issue 80 13.3 7.75

Preferred stock 100 16.7 6

Common stock 300 50 16

$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 the 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.

Questions needed to be answered

1. What is the cost of equity using the dividend discount model?

2. What is the Cost of Preferred Stock

3. What is the cost of debt?

4. The weight of each component % of each.

5. WACC calculation.

6. Why is the Boss's calculation wrong?