Determining the Cost of Capital Hubbardton Iron Works The Hubbardton Iron Works Corporation (HIWC), a Boston based company was established in 2000. Harold Tugman, IV founded the corporation which was privately owned at the time, after retiring from General Tugboats Corporation. HIWC was original fomed to provide ship repair services and eamed the Department of Defense certified Alteration Boat Repair designation. Among its specialties were structural welding, piping system installation and repairs, electrical, painting, rigging, machinery and dry-dock work, as well as custom sheet metal fabrication. Other divisions of HIWC included Habitability Installation, Industrial Contracting and Alteration/Installation Teams. With its initial success and good return on investment the fims operated facilities in New Jersey, Maryland, Pennsylvania, Florida and Virginia In 2008 the company went public and its initial public offering was very successful. The stock price rose from its initial value of $10 to its current level of $35 per share. There are currently 5 million shares outstanding. In 2010 the company issued 30 year bonds at par, with a face value of S1000 and a coupon rate of 10% per year and managed to raise $0 million for expansion. Currently, the AA rated bonds have 20 years left until maturity and are quoted at 91.5% of par. Over the past year, HIWC utilized a new method for fabricating composite material that the firm's engineers developed. In June of last year, management established the Advanced Materials Group (AM Group), which was dedicated to pursuing technology. The firm recruited Harry Stone, a senior engineer, to head the group. Harry has an MBA from a prestigious university Upon joining HIWC, Harry realized that most projects were being approved on a "gut feeling 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 the company had benefited from good relationships with its clients and suppliers. This informal method has to change, said Harry to his assistant Stephanie, "we cannot possibly be this lucky forever. We need to calculate the firm's cost of capital and use it in the future." Stephanie replied, "Yes, Harry, why don't I crunch out the number and give them to you within the next couple of days?" "That sounds great, Stephanie," said Harry. "My years of experience tell me that when it comes to the cost of capital for new projects, one size never fits all." As Stephanie began looking at the financial statements, she realized she was going to have to make some assumptions 1. She assumed the new debt would cost about the same as the yield on the outstanding debt and would have the same rating. 2. She assumed the fimm would continue raising capital for future projects by using the same target proportions as determined by the book values of debt and equity (see Table 1 for the recent balance sheet). 3. She assumed the equity beta (1.5) would be the same for all divisions, 4. She assumed the historical growth rates of earnings and dividends would continue at their historical rate (see Table 2 for camings and dividends history). 5. She assumed the corporate tax would be 34% 6. The 1-year Treasury bill yield was 4% and the expected return on the market portfolio was 10% TABLE 1 HIWC Balance Sheet ('000) Cash Accounts Receivable Inventory Total Current Assets 5000 10000 20000 35000 Accounts Payable Accruals Notes Payable Total Current Assets 8000 5000 10000 23000 40000 Land& Buildings Plant& Equipment Total Fixed Assets 43000 45000 88000 Long Term Debt Common Stock 5 million outstanding Retained Earnings 50000 10000 Total Assets 123000 Total Liabilities and Shareholder equity 123000 TABLE 2 HIWC Sales, Earnings and Dividend History (000s) Earnings Per Share Dividends Per Share Year Sales 2012 2013 2014 2015 2016 2017 2018 $24,000,000 28,800,000 36,000,000 45,000,000 57,750,000 62,100,000 74,520,000 $0.48 0.58 0.72 0.86 0.96 1.06 1.20 $0.10 0.12 0.15 0.18 0.20 Questions: 1. Why do you think Harry Stone wants to estimate the fim's cost of capital? Is it justified to use the firm's weighted average cost of capital as the divisional cost of capital? Explain. 2. How should Stephanie go about figuring the cost of debt? Calculate the firm's cost of debt. 3. Comment on each of Stephanie's assumptions. Are they realistic, why or why not? 4. Why is there a cost associated with a fim's retained eamings? 5. How can Stephanie estimate the firm's cost of retained carnings? Should it be adjusted for taxes? Explain. 6. Calculate the firm's average cost of retained earnings. 7. How should Stephanie calculate the firm's cost of capital? Calculate it and explain the various steps. & Can Harry assume the cost of capital calculated by Stephanie remains constant? Explain. Determining the Cost of Capital Hubbardton Iron Works The Hubbardton Iron Works Corporation (HIWC), a Boston based company was established in 2000. Harold Tugman, IV founded the corporation which was privately owned at the time, after retiring from General Tugboats Corporation. HIWC was original fomed to provide ship repair services and eamed the Department of Defense certified Alteration Boat Repair designation. Among its specialties were structural welding, piping system installation and repairs, electrical, painting, rigging, machinery and dry-dock work, as well as custom sheet metal fabrication. Other divisions of HIWC included Habitability Installation, Industrial Contracting and Alteration/Installation Teams. With its initial success and good return on investment the fims operated facilities in New Jersey, Maryland, Pennsylvania, Florida and Virginia In 2008 the company went public and its initial public offering was very successful. The stock price rose from its initial value of $10 to its current level of $35 per share. There are currently 5 million shares outstanding. In 2010 the company issued 30 year bonds at par, with a face value of S1000 and a coupon rate of 10% per year and managed to raise $0 million for expansion. Currently, the AA rated bonds have 20 years left until maturity and are quoted at 91.5% of par. Over the past year, HIWC utilized a new method for fabricating composite material that the firm's engineers developed. In June of last year, management established the Advanced Materials Group (AM Group), which was dedicated to pursuing technology. The firm recruited Harry Stone, a senior engineer, to head the group. Harry has an MBA from a prestigious university Upon joining HIWC, Harry realized that most projects were being approved on a "gut feeling 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 the company had benefited from good relationships with its clients and suppliers. This informal method has to change, said Harry to his assistant Stephanie, "we cannot possibly be this lucky forever. We need to calculate the firm's cost of capital and use it in the future." Stephanie replied, "Yes, Harry, why don't I crunch out the number and give them to you within the next couple of days?" "That sounds great, Stephanie," said Harry. "My years of experience tell me that when it comes to the cost of capital for new projects, one size never fits all." As Stephanie began looking at the financial statements, she realized she was going to have to make some assumptions 1. She assumed the new debt would cost about the same as the yield on the outstanding debt and would have the same rating. 2. She assumed the fimm would continue raising capital for future projects by using the same target proportions as determined by the book values of debt and equity (see Table 1 for the recent balance sheet). 3. She assumed the equity beta (1.5) would be the same for all divisions, 4. She assumed the historical growth rates of earnings and dividends would continue at their historical rate (see Table 2 for camings and dividends history). 5. She assumed the corporate tax would be 34% 6. The 1-year Treasury bill yield was 4% and the expected return on the market portfolio was 10% TABLE 1 HIWC Balance Sheet ('000) Cash Accounts Receivable Inventory Total Current Assets 5000 10000 20000 35000 Accounts Payable Accruals Notes Payable Total Current Assets 8000 5000 10000 23000 40000 Land& Buildings Plant& Equipment Total Fixed Assets 43000 45000 88000 Long Term Debt Common Stock 5 million outstanding Retained Earnings 50000 10000 Total Assets 123000 Total Liabilities and Shareholder equity 123000 TABLE 2 HIWC Sales, Earnings and Dividend History (000s) Earnings Per Share Dividends Per Share Year Sales 2012 2013 2014 2015 2016 2017 2018 $24,000,000 28,800,000 36,000,000 45,000,000 57,750,000 62,100,000 74,520,000 $0.48 0.58 0.72 0.86 0.96 1.06 1.20 $0.10 0.12 0.15 0.18 0.20 Questions: 1. Why do you think Harry Stone wants to estimate the fim's cost of capital? Is it justified to use the firm's weighted average cost of capital as the divisional cost of capital? Explain. 2. How should Stephanie go about figuring the cost of debt? Calculate the firm's cost of debt. 3. Comment on each of Stephanie's assumptions. Are they realistic, why or why not? 4. Why is there a cost associated with a fim's retained eamings? 5. How can Stephanie estimate the firm's cost of retained carnings? Should it be adjusted for taxes? Explain. 6. Calculate the firm's average cost of retained earnings. 7. How should Stephanie calculate the firm's cost of capital? Calculate it and explain the various steps. & Can Harry assume the cost of capital calculated by Stephanie remains constant? Explain