How can one estimate the cost of external equity under various methods (Q10)? Further explanation and detail can be found at the bottom if needed.

Case 100 Pressed Paper Products, Inc. Cost of Capital Directed Pressed Paper Products, Inc. (PPP) operates a paper mill on the White River in central New Hampshire. Mount Washington and the Presidential Ranges can be seen on the horizon to the north of the plant. The plant has been operated continuously since 1710 and produces many non-woven paper pulp products. Its most famous product is tea bag paper, which the company started producing in the late 19" century. Tea bag paper is manufactured from trees and recycled paper pulp. Sheets of fibrous, non-woven material are pressed and cut to tea bag size, and then sold to tea manufacturers where they are filled with chopped tea leaves, sealed, and strings or tags are attached. The fibrous paper is completely porous and allows water to flow freely through the tea, while the leaves are contained within the bag. The tea bag method of tea brewing is used primarily in Europe and the Americas. Asian cultures normally prefer to brew tea with whole leaves and without paper filtering bags. PPP is one of the oldest companies on the American Stock Exchange but has been publicly traded for only 50 years. It has broadened its product line to include numerous specialty materials, including medical gauze, egg carton board, cigarette wrappers and filters, and food and beverage can varnishes. The company also owns controlling interest in a very profitable Silicon Valley technology firm. Although now a diversified company, tea bag paper is the root of the company. Currently, three companies produce 88% of the tea bag paper in the world: Pressed Paper Products, The Great Paper Company of Edinburgh (located in Scotland) and Lincoln Paper and Fiber (located in northern Illinois). The tea bag paper market is nearly evenly split among these three companies, and prices have been driven to commodity levels that are only slightly more than the variable costs of production. For years, rumors have persisted about Edinburgh's financial struggles and that management may entertain acquisition offers. Last year their investment bankers began discussing the possibility of a sale with potential buyers. Because of the Edinburgh's debt levels (85% debt to total capital) and slipping market share, PPP was hesitant to pursue an acquisition. However, management believes that Lincoln Paper and Fiber is considering the acquisition. The Board of Directors is concerned that if their primary competitor controls a major interest in the market, additional price and cost pressure will hurt PPP's tea bag paper unit. Therefore, PPP's Board of directors is considering the acquisition to keep Lincoln from increasing their market share. To help in the decision process PPP is interested in determining whether the return generated from the purchase will cover Lincoln's cost of capital. Analysts believe that, given current market and company conditions, Lincoln is at its target capital structure and the company will maintain this mix of debt and equity. Relatives of Lincoln's founder own forty percent of Lincoln's equity. The company has a high dividend payout ratio that provides a major source of income for these family members, and therefore, it is not expected to change. Additionally, it recently completed an acquisition of another paper company bringing tea bag paper to about 25 percent of company sales. Because of this purchase, near-term free cash flow is tight, new debentures were issued and the company maintains a two-year-old callable bond that was issued with a five year deferred call provision requiring a call premium of one-year interest. Assimilating the acquisitionCase 100 Pressed Paper Products, Inc. Cost of Capital Directed Pressed Paper Products, Inc. (PPP) operates a paper mill on the White River in central New Hampshire. Mount Washington and the Presidential Ranges can be seen on the horizon to the north of the plant. The plant has been operated continuously since 1710 and produces many non-woven paper pulp products. Its most famous product is tea bag paper, which the company started producing in the late 19" century. Tea bag paper is manufactured from trees and recycled paper pulp. Sheets of fibrous, non-woven material are pressed and cut to tea bag size, and then sold to tea manufacturers where they are filled with chopped tea leaves, sealed, and strings or tags are attached. The fibrous paper is completely porous and allows water to flow freely through the tea, while the leaves are contained within the bag. The tea bag method of tea brewing is used primarily in Europe and the Americas. Asian cultures normally prefer to brew tea with whole leaves and without paper filtering bags. PPP is one of the oldest companies on the American Stock Exchange but has been publicly traded for only 50 years. It has broadened its product line to include numerous specialty materials, including medical gauze, egg carton board, cigarette wrappers and filters, and food and beverage can varnishes. The company also owns controlling interest in a very profitable Silicon Valley technology firm. Although now a diversified company, tea bag paper is the root of the company. Currently, three companies produce 88% of the tea bag paper in the world: Pressed Paper Products, The Great Paper Company of Edinburgh (located in Scotland) and Lincoln Paper and Fiber (located in northern Illinois). The tea bag paper market is nearly evenly split among these three companies, and prices have been driven to commodity levels that are only slightly more than the variable costs of production. For years, rumors have persisted about Edinburgh's financial struggles and that management may entertain acquisition offers. Last year their investment bankers began discussing the possibility of a sale with potential buyers. Because of the Edinburgh's debt levels (85% debt to total capital) and slipping market share, PPP was hesitant to pursue an acquisition. However, management believes that Lincoln Paper and Fiber is considering the acquisition. The Board of Directors is concerned that if their primary competitor controls a major interest in the market, additional price and cost pressure will hurt PPP's tea bag paper unit. Therefore, PPP's Board of directors is considering the acquisition to keep Lincoln from increasing their market share. To help in the decision process PPP is interested in determining whether the return generated from the purchase will cover Lincoln's cost of capital. Analysts believe that, given current market and company conditions, Lincoln is at its target capital structure and the company will maintain this mix of debt and equity. Relatives of Lincoln's founder own forty percent of Lincoln's equity. The company has a high dividend payout ratio that provides a major source of income for these family members, and therefore, it is not expected to change. Additionally, it recently completed an acquisition of another paper company bringing tea bag paper to about 25 percent of company sales. Because of this purchase, near-term free cash flow is tight, new debentures were issued and the company maintains a two-year-old callable bond that was issued with a five year deferred call provision requiring a call premium of one-year interest. Assimilating the acquisitionwas more difficult than what analysts initially believed and share price has dropped since the acquisition was first announced. Based on information obtained at a recent trade fair, PPP estimates that Lincoln will require $20 million to maintain its core business operations. These essential activities must be funded. After that, the company will consider other optional but interesting capital projects requested by its division managers. A table of estimated available projects with corresponding capital requirements and expected returns is listed below: Investment Opportunity Schedule Rate of Return Capital Required 9.25% Essential Projects $20 million Edinburgh Acquisition $150 million 9.00% 12.25% New Paper Machine $55 million 10.50% Plant Construction $120 million Assume it is 2004 and interest levels are at historically low levels. PPP's management has asked you to prepare a report analyzing whether Lincoln can profitably take on the purchase of Edinburgh and whether PPP should pursue the acquisition to preserve its market position. Since the report will be presented to the Board of Directors, it is critical to address all of the issues that affect capital costs. In the process of preparing your report, you have gathered the following supplemental information from publicly available sources: 1. The current bond quotes for the callable bond followed by the debentures: BONDS Coupon Maturity Est. Vol. Last Price (000's) Lincoln National (LCN) - callable 10.500 2019 90 1 12.500 Lincoln National (LCN) 7.7500 2020 530 98.400 This senior debt is not mortgage debt or otherwise covenanted. Assume that the book value of property, plant and equipment is approximately equal to its market value and a 50 basis point (0.5%) discount is available for mortgage debt. However, total mortgage debt cannot exceed 10% of the book value of equity. Based on discussions with market analysts and investment bankers, PPP believes that the costs associated with a debt issue, including legal fees, investment bank fees and other costs, are 2% of the proceeds of the debt issue. The company considers these costs relevant to the cost of debt. 2 . Lincoln's current debt rating is BBB. This is the lowest debt rating that is considered "investment-grade." Based on other debt issues, analysts expect that the ratings agencies would allow an additional $50,000,000 in straight debtures before grading any additional subordinated debt lower. A lower debt rating for the subordinated or junior debt would add 300 basis points (3.0%) to the expected yield of the company's senior debt. 3a. Quotes on long-term Treasury Bonds (decimal represented in 32nds). The company assumes the bond closest to a 10-year maturity represents the risk-free rate. Rate Maturity Bid Asked Change 3.250 Ask Yield Aug 07 104:12 104:13 10.625 Aug 15 +.08 165.28 165.30 1.74% 5.375 Feb 31 1 12.19 Unch 1 12.20 3.39% +.017 4.56%was more difficult than what analysts initially believed and share price has dropped since the acquisition was first announced. Based on information obtained at a recent trade fair, PPP estimates that Lincoln will require $20 million to maintain its core business operations. These essential activities must be funded. After that, the company will consider other optional but interesting capital projects requested by its division managers. A table of estimated available projects with corresponding capital requirements and expected returns is listed below: Investment Opportunity Schedule Rate of Return Capital Required 9.25% Essential Projects $20 million Edinburgh Acquisition $150 million 9.00% 12.25% New Paper Machine $55 million 10.50% Plant Construction $120 million Assume it is 2004 and interest levels are at historically low levels. PPP's management has asked you to prepare a report analyzing whether Lincoln can profitably take on the purchase of Edinburgh and whether PPP should pursue the acquisition to preserve its market position. Since the report will be presented to the Board of Directors, it is critical to address all of the issues that affect capital costs. In the process of preparing your report, you have gathered the following supplemental information from publicly available sources: 1. The current bond quotes for the callable bond followed by the debentures: BONDS Coupon Maturity Est. Vol. Last Price (000's) Lincoln National (LCN) - callable 10.500 2019 90 1 12.500 Lincoln National (LCN) 7.7500 2020 530 98.400 This senior debt is not mortgage debt or otherwise covenanted. Assume that the book value of property, plant and equipment is approximately equal to its market value and a 50 basis point (0.5%) discount is available for mortgage debt. However, total mortgage debt cannot exceed 10% of the book value of equity. Based on discussions with market analysts and investment bankers, PPP believes that the costs associated with a debt issue, including legal fees, investment bank fees and other costs, are 2% of the proceeds of the debt issue. The company considers these costs relevant to the cost of debt. 2 . Lincoln's current debt rating is BBB. This is the lowest debt rating that is considered "investment-grade." Based on other debt issues, analysts expect that the ratings agencies would allow an additional $50,000,000 in straight debtures before grading any additional subordinated debt lower. A lower debt rating for the subordinated or junior debt would add 300 basis points (3.0%) to the expected yield of the company's senior debt. 3a. Quotes on long-term Treasury Bonds (decimal represented in 32nds). The company assumes the bond closest to a 10-year maturity represents the risk-free rate. Rate Maturity Bid Asked Change 3.250 Ask Yield Aug 07 104:12 104:13 10.625 Aug 15 +.08 165.28 165.30 1.74% 5.375 Feb 31 1 12.19 Unch 1 12.20 3.39% +.017 4.56%3b. Quotes on Treasury bills Maturity Bid Asked Change Ask Yield Jul 08 1.08 1.07 Unch 1.07% Sep 23 1.12 1.11 Unch 1.11% Jan 13 1.15 1.14 -0.02 1.167 4. Lincoln's current common stock quote: 52-week YLD HI LO Stock (SYM) VOL Div PE (100s) 9.06 19.13 Lincoln (LCN) Close .70 6.63 12.28 127 10.56 5. The company prefers dividend payout ratios of 22 percent, however last year the company faced unique circumstances resulting in a higher payout ratio. The company prefers share repurchase to dividend payout increases in years that earnings are abnormally high. Generally, the company has returns on equity of around 12.5%. 6. Assume a historical market risk premium of 7.1% (according to Stocks, Bonds, Bills, and Inflation Yearbook, Ibbotson Associates). Lincoln has a beta of 0.89, as reported by Market Guide analysts. Assume the corporate beta will be stable for this transaction, as analysts estimate that paper products follow similar volatility patterns across the paper production industry. 7. Wall Street growth projections for Lincoln's earnings suggest long-term corporate growth of 5%, according to Bloomberg Network. 8. Equity flotation costs are expected to be 7% of proceeds. 9. Ibbotson data indicates that historically bonds have yielded about 7 percent more than stocks, but their report indicates that the historical risk premium may be too high. Thus, the company feels a 4% premium is more representative. 10. Lincoln has a corporate tax rate of 34.6%. 2004 South-Western, a part of Cengage Learning3b. Quotes on Treasury bills Maturity Bid Asked Change Ask Yield Jul 08 1.08 1.07 Unch 1.07% Sep 23 1.12 1.11 Unch 1.11% Jan 13 1.15 1.14 -0.02 1.167 4. Lincoln's current common stock quote: 52-week YLD HI LO Stock (SYM) VOL Div PE (100s) 9.06 19.13 Lincoln (LCN) Close .70 6.63 12.28 127 10.56 5. The company prefers dividend payout ratios of 22 percent, however last year the company faced unique circumstances resulting in a higher payout ratio. The company prefers share repurchase to dividend payout increases in years that earnings are abnormally high. Generally, the company has returns on equity of around 12.5%. 6. Assume a historical market risk premium of 7.1% (according to Stocks, Bonds, Bills, and Inflation Yearbook, Ibbotson Associates). Lincoln has a beta of 0.89, as reported by Market Guide analysts. Assume the corporate beta will be stable for this transaction, as analysts estimate that paper products follow similar volatility patterns across the paper production industry. 7. Wall Street growth projections for Lincoln's earnings suggest long-term corporate growth of 5%, according to Bloomberg Network. 8. Equity flotation costs are expected to be 7% of proceeds. 9. Ibbotson data indicates that historically bonds have yielded about 7 percent more than stocks, but their report indicates that the historical risk premium may be too high. Thus, the company feels a 4% premium is more representative. 10. Lincoln has a corporate tax rate of 34.6%. 2004 South-Western, a part of Cengage LearningLincoln Paper and Fiber - Consolidated Balance Sheets (December 31) (in thousands) 2002 2003 ASSETS 10,079 $ 9,234 Cash and cash equivalents 58,932 65,457 Marketable securities 183,727 168,874 Accounts receivable 168, 724 158,819 Inventories 32, 457 26,895 Other Current Assets 3,560 2,426 Prepaid expenses 457,479 431,705 Total current assets 758, 197 785,818 Property, Plant & Equip. 375,537 359,275 Accumulated Depreciation 426,543 Net Prop & Equip 382,660 201,098 166,461 Other non-current assets Total assets $ 1,041,237 $ 1,024,710 LIABILITIES AND SHAREHOLDERS' EQUITY Notes Payable 30,137 25,247 Accounts payable 43,462 42,299 Current portion of long-term debt $ 13,432 $ 12,975 Accrued compensation, other expenses 69,807 67,022 Accrued 'Federal, state and local taxes 19,154 24,545 Other current Liab. 7,577 7,243 Total current liabilities 183,569 179,331 Deferred Charges 52, 179 47,824 Long-term debt b 330,000 330,000 Total liabilities 565,748 557,155 SHAREHOLDERS' EQUITY Common stock " 654 Capital in excess of par value 654 51,148 Retained earnings 50,921 Total Shareholders equity 423,688 415.980 475,489 467,555 Total liabilities and shareholders' equity a. Less allowance for doubtful accounts. $ 1,041,237 $ 1,024,710 b. All bonds were issued at par. The mix of long term debt is one-third debentures and two-thirds callable bonds all issued at par. shares issued. " Common stock has a par value of $.01; 120,000,000 are shares authorized and 65,421,877 areLincoln Paper and Fiber - Consolidated Balance Sheets (December 31) (in thousands) 2002 2003 ASSETS 10,079 $ 9,234 Cash and cash equivalents 58,932 65,457 Marketable securities 183,727 168,874 Accounts receivable 168, 724 158,819 Inventories 32, 457 26,895 Other Current Assets 3,560 2,426 Prepaid expenses 457,479 431,705 Total current assets 758, 197 785,818 Property, Plant & Equip. 375,537 359,275 Accumulated Depreciation 426,543 Net Prop & Equip 382,660 201,098 166,461 Other non-current assets Total assets $ 1,041,237 $ 1,024,710 LIABILITIES AND SHAREHOLDERS' EQUITY Notes Payable 30,137 25,247 Accounts payable 43,462 42,299 Current portion of long-term debt $ 13,432 $ 12,975 Accrued compensation, other expenses 69,807 67,022 Accrued 'Federal, state and local taxes 19,154 24,545 Other current Liab. 7,577 7,243 Total current liabilities 183,569 179,331 Deferred Charges 52, 179 47,824 Long-term debt b 330,000 330,000 Total liabilities 565,748 557,155 SHAREHOLDERS' EQUITY Common stock " 654 Capital in excess of par value 654 51,148 Retained earnings 50,921 Total Shareholders equity 423,688 415.980 475,489 467,555 Total liabilities and shareholders' equity a. Less allowance for doubtful accounts. $ 1,041,237 $ 1,024,710 b. All bonds were issued at par. The mix of long term debt is one-third debentures and two-thirds callable bonds all issued at par. shares issued. " Common stock has a par value of $.01; 120,000,000 are shares authorized and 65,421,877 areLincoln Paper and Fiber - Income Statement (in thousands) Sales Other income $652, 189 Total income $52,465 $704,654 Cost of products sold Depreciation Charged $506,796 $42,955 Selling, general and administrative expenses Total Operating Costs $44,171 $593,922 Earnings before interest and taxes (EBIT) $110,732 Less Interest $22,440 Earnings Before Taxes (EBT) $88,292 Taxes $30,549 Net Income before preferred dividends $57, 743 Preferred dividends Net income available to common stockholders $57, 743 Common dividends $45,795 Addition to retained earnings $11,948Lincoln Paper and Fiber - Income Statement (in thousands) Sales Other income $652, 189 Total income $52,465 $704,654 Cost of products sold Depreciation Charged $506,796 $42,955 Selling, general and administrative expenses Total Operating Costs $44,171 $593,922 Earnings before interest and taxes (EBIT) $110,732 Less Interest $22,440 Earnings Before Taxes (EBT) $88,292 Taxes $30,549 Net Income before preferred dividends $57, 743 Preferred dividends Net income available to common stockholders $57, 743 Common dividends $45,795 Addition to retained earnings $11,948payout ratio. In this case why would the company prefer the analysts' forecasts of growth? What other methods can be used to find a growth rate? Why do these methods differ from the cost found using the CAPM? d. Find the yield on Lincoln's debentures and find the cost of retained earnings this method. using the bond-yield-plus-risk-premium method. Explain the rational behind 9. Given the different costs found by the DCF, the CAPM and theond-yield-plus-risk- premium method, what is your best estimate for the cost of internal equity? Explain how you decided what weight to give to each estimating technique. 10. Estimate the cost of external equity under various methods. a. What is your estimate of Lincoln's cost of new common stock using the DCF method and the analysts' expectations of long term growth? b. Based on the DCF what is the flotation adjustment for new common stock over retained earnings? c. Adjusting for flotation what is the estimate of the cost of external equity. 11. What are the limits of funding for equity and debt? Based on its market value capital structure, at what points in required funding would Lincoln be required to use more expensive capital to fund its capital budgeting needs. 12 The Marginal Cost of Capital schedule (MCC) a. Explain and construct the MCC using the market value capital structure. Ignore depreciation at this point. b. Would the MCC schedule remain constant beyond the final WACC break point, no matter how much new capital is raised? Explain. Again, ignore depreciation. 13. The Investment Opportunity Schedule (IOS) a. Explain and construct the company's IOS realizing that the essential projects are required. b. Using the IOS and MCC, explain which projects are acceptable. 14. How does depreciation affect the MCC schedule? If depreciation were included, could this affect the acceptability of proposed capital projects? Explain.payout ratio. In this case why would the company prefer the analysts' forecasts of growth? What other methods can be used to find a growth rate? Why do these methods differ from the cost found using the CAPM? d. Find the yield on Lincoln's debentures and find the cost of retained earnings this method. using the bond-yield-plus-risk-premium method. Explain the rational behind 9. Given the different costs found by the DCF, the CAPM and theond-yield-plus-risk- premium method, what is your best estimate for the cost of internal equity? Explain how you decided what weight to give to each estimating technique. 10. Estimate the cost of external equity under various methods. a. What is your estimate of Lincoln's cost of new common stock using the DCF method and the analysts' expectations of long term growth? b. Based on the DCF what is the flotation adjustment for new common stock over retained earnings? c. Adjusting for flotation what is the estimate of the cost of external equity. 11. What are the limits of funding for equity and debt? Based on its market value capital structure, at what points in required funding would Lincoln be required to use more expensive capital to fund its capital budgeting needs. 12 The Marginal Cost of Capital schedule (MCC) a. Explain and construct the MCC using the market value capital structure. Ignore depreciation at this point. b. Would the MCC schedule remain constant beyond the final WACC break point, no matter how much new capital is raised? Explain. Again, ignore depreciation. 13. The Investment Opportunity Schedule (IOS) a. Explain and construct the company's IOS realizing that the essential projects are required. b. Using the IOS and MCC, explain which projects are acceptable. 14. How does depreciation affect the MCC schedule? If depreciation were included, could this affect the acceptability of proposed capital projects? Explain