Figure 13.2 (Chapter 13) Return to Figure 13.2. Sea Shore Salt Company Spring Vacation Beach, Florida CONFIDENTIAL MEMORANDUM DATE: January 15, 2018 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): Bank loan \$120, Bond Issue \$80, Preferred Stock $100, Common Stock $300, Total: $600. Percent of total: Bank loan 20\%, Bond issue 13.3%, Preferred stock 16.7%, Common stock 50%. Rate of Return: Bank loan 8%, Bond issue 7.75%, Preferred stock 6%, Common stock 16%. 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 21% tax rate, is 8(1 .21)=6.3% Figure 13.2 (Chapter 13) Return to Figure 13.2. Sea Shore Salt Company Spring Vacation Beach, Florida CONFIDENTIAL MEMORANDUM DATE: January 15, 2018 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): Bank loan \$120, Bond Issue \$80, Preferred Stock $100, Common Stock $300, Total: $600. Percent of total: Bank loan 20\%, Bond issue 13.3%, Preferred stock 16.7%, Common stock 50%. Rate of Return: Bank loan 8%, Bond issue 7.75%, Preferred stock 6%, Common stock 16%. 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 21% tax rate, is 8(1 .21)=6.3%