Cost of capital memo

Suds em Strong Company

Lave Plains, Montana

CONFIDENTIAL MEMORANDUM

DATE: June 30, 2020

TO: S.M.S. Management

FROM: Hal Kleanz, President

SUBJECT: Cost of Capital

This memo states and clarifies our companys long-standing policy regarding hurdle rates for capital investment decisions. There have been many recent questions, and some evident confusion, on this matter. Suds em Strong evaluates replacement and expansion investments by discounted cash flow. The discount or hurdle rate is the companys after-tax weighted-average cost of capital (WACC). The WACC 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 own stock in our company.

The following table summarized the composition of Suds em Strongs financing.

	Amount (in millions)	Percent in Total	Rate of Return
Bank Loan	$130	16.25%	8.5%
Bond issue	250	31.25	7.9
Preferred stock	80	10.00	4.2
Common stock	340	42.50	15
Total	800	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 show above. For example, the after-tax cost of our bank financing, given our 25% tax rate, is 8.5 (1 - .25) = 6.375%. The rate of return on preferred stock is 4.2%. Suds em Strong pays a dividend of $4.20 on each $100 preferred share.

Our target rate of return on equity has been 15% for many years. I know that some newcomers think this target is too high for the safe and mature soap business. But we must all aspire to superior profitability.

Once this background is absorbed, the calculation of Suds em Strongs weighted-average cost of capital (WACC) is elementary:

WACC = 8.5 (1 - .25) (.1625) + 7.9 (1 - .25) (.3125) + 4.2 (.10) + 15 (.4250) = 9.68%

The official corporate hurdle rate is therefore 9.68%.

If you have further questions about these calculations, please direct them to our new Treasury Analyst, Kris Pickett. It is a pleasure to have Kris back at Suds em Strong after a years leave of absence to complete a degree in finance.

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Kris first examined Suds em Strongs most recent balance sheet, summarized near the end of the problem, then jotted down the following additional points:

• The companys 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.
• The preferred stock had been issued 35 years ago, when interest rates were much lower. The preferred stock was now trading for only $77 per share.
• The common stock traded for $62 per share. Next years earnings per share would be about $5.30 and dividends per share probably $2.80. Suds em Strong had traditionally paid out approximately 50% of earnings as dividends and plowed back the rest.
• Earnings and dividends had grown steadily at 4% to 5% per year, in line with the companys sustainable growth rate:

Sustainable Growth Rate = Return on Equity x Retention Rate

= 5.30/62 x .5

= .0427. or 4.27%

• Suds em Strongs had an average beta about 0.4, which made sense, Kris thought, for a stable, steady-growth business. Using the capital asset pricing model (CAPM), Kris made a quick cost of equity calculation. With current interest rates of about 5.5%, and a market risk premium of 7%, the cost of equity calculated with the CAPM was significantly less than the 15% decreed in Mr. Kleanzs memo.

Kris quickly scanned the accumulated notes. What if Mr. Kleanzs 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? Kris resolved to complete the analysis that night. If necessary, Kris would try to speak with Mr. Kleanz when he arrived at his office the next morning. Kris job was not just finding the right number, but also to figure out how to explain it all to Mr. Kleanz.

Suds em Strongs balance sheet, taken from the companys 2019 balance sheet (figures in millions)

Assets		Liabilities & Net Worth
Working Capital	$330	Bank Loan	$130
Plant & Equipment	$420	Long-term debt	$250
Other assets	$50	Preferred Stock	$80
		Common Stock including retained earnings.	$340
Total	$800	Total	$800

Notes:

1. At year-end 2019, Suds em Strong had 10 million common shares outstanding.
2. The company had also issued 800,000 preferred shares with book value of $100 per share. Each share receives an annual dividend of $4.20.

Requirements:

• Use the CAPM and numbers given to substantiate Kris claim that the cost of equity is substantially lower than 15%.
• Calculate a market value weighted average cost of capital.
• Draft a short response that Kris could share with Mr. Kleanz explaining the rationale behind the revised numbers for cost of equity and cost of capital.