COBA Corporation the value of each was calculated using market weights. She knew, for instance, that debt identical to the 9 Risk Management and Corporate Capital Costs percent debt now outstanding for COBA could be issued with a 7 percent yield. The market value of the common stock was $21 at present. As a result of that information a market value capital structure would have to be calculated as a part of her task. (Recall that the firm's income tax rate is 35 percent.) In addition to the capital structure explanation. Sims wanted to make sure that the delineation of the After the meeting. Tiffin and Bergerson were feeling some relief and some apprehension over the Cost of equity calculations was clear. She wanted to illustrate a smooth transition from the dividend model to things went. They were relieved because they believed that Kenner now fully understood why they a more market oriented model. The capital asset pricing model, which Sims' finance professor insisted was Financial decisions in such a manner. In addition, the more experienced financial staff from each superior to internally influenced models such as the dividend model, was the analytical approach she wanted Jivisions were also "tuned in. Their apprehension arose, however, from a series of questions raised by to emulate. Specifically, the individual company aspect of the CAPM known as the security market line Sims, a finance major and summer intern from a nearby university. Sims' questions seemed to imply would be itsed to calculate the firm's equity cost, the required yield on equity. COBA's approach to cost of capital calculations was less than up-to-date. Sims knew, for example, that the parameters for the SML included a risk-free (or, very low risk) The young summer intem was especially interested in Tiffin and Bergerson's views concernin interest rate, the return on a market average of common stock, and the firm's beta. Further, it was clear that a book versus market cost of capital. For example, how did these differ and did the difference, if any, inilt low risk proxy used in the SML was the retum on U.S. Treasury bills. The bonds outstanding: have an the manner in which capital budgeting was conducted, or the results which were obtained in other w assumed maturity value of $1.000 and a remaining maturity of 15 years. In addition, the imbalance on the Vs. Sims wanted to make clear the following points: (1) The dividend model had some inh halance sheet resulting from the market value of capital would be corrected by assigning replacement value to shortcomings, and (2) Capital investment decisions, the primary use for the cost of capital, should be the land, huildings, and equipment. with regard to marginal cost as well as marginal revenue. The fim's beta could be calculated or simply found in one of several publications which carried These issues and concerns were not new to Tillin and Bergerson. They were sure that cach of: Financial ratios and similar information. The return on the market index could he calculated or assumed be points was relevant and they decided that all matters concerning the cost of capital had to he cloure represented by the ROE of a broad market index such a number was approximately 12.5 percent at the end immediately. Only then could it he decided whether another meeting with Kenner and the divisional fin 1942). Sims, equipped with the foregoing data and information believed she was ready to prepare an up- and accounting staff was warranted. In order to resolve things in the most efficient manner possible, a sp to-date cost of capital for the company. project was designed for Sims. The return on the market calculation may be handled in at least two ways: (1) By subtracting from the In essence, Tiffin and Bergerson wanted Sims to design a cost of capital manual for use by C historical average return on common stock the historical average return on high-grade corporate bonds and management. The issues to be dealt with in the manual were those alluded to by Sims earlier. These coul adding the difference to the currently prevailing rate on high-grade corporate bonds, or (2) A specific pool of enumerated as follows: stocks (all industrial stocks or all utility stocks) might be assessed for their level of return over some time period. In any case, the objective is to obtain as representative a figure as possible relative to the factors that 1 Explain the difference between book value cost of capital and market value cost of capital influence stock retums. 2 Discuss an alternative to the dividend model of use in calculating the cost of eq TABLE 1 Specifically outline, in clear detail, the Capital Asset Pricing Model (CAPM) approach COBA Corporation cost of equity Balance Sheer December 31, 1992 3. Concerning Item 2, describe the sources for the parameters of the CAPM or its rele (000) component, the Security Market Line (SML). Total current assets $800 Total current liabilities 4 What effect, if any, will any changes to the cost of capital calculation have upon the fi $250 capital budgeting activities and the number and type of projects it ultimately accepts? Land $8.000 Long-term debt (at 9%) 21.750 Buildings (net) 26,000 Common stock The issues that Sims wanted to clarify for the company would influence the policy set by the concerning financial matters. As a result, the firm's strategy would also be influenced. The pri Equipment (net) 12.200 (2m shares outstanding) 20,000 considerations of risk in capital budgeting was important; it was also multifaceted. Sims wanted a cl Total fixed assets cohesive set of guidelines for the firm to follow 46.200 Retained earnings 5.000 The cost of capital for the firm was influenced by the cost of capital for the two divisions. E division's cost of capital would, in a CAPM setting. be based upon the particular characteristics of individual division. The idea and practice of comparing an operating division to a firm which operates se Total assets $47,000 Total liabilities and net worth $47.000 in that line of business was known as the "pure-play" technique. Therefore, the debt level of a division's p play, and the cost of debt which resulted from that debt level. helped to determine the division's cos capital. In general, the greater the debt level of a division, the greater the division's beta coefficient measures the nondiversifiable risk of a security, such as a company's stock, or an operating division Questions company.) Sims began work on the assignment immediately. She believed that a thorough job would be good What is COBA's cost of equity using the SML (CAPM? Explain the difterence between these the progressive and well-run company and would also assure her a more permanent position them. As a re of these motivations. Sims wanted to be as systematic as possible in her task. As a first step she wante numbers. (Assume that the risk free rate of interest is 5 percent, and the firm's leta is 1.+). recast the company's balance sheet shown in lable 1. in the most current manner possible. It was clear to Sins that the long-term capital items in the capital structure would appear different What is COBA's weighted average market value cost of capital using the information in Question abere