"How would the cost of debt be calculated if we reflect an interest rate of $8\%$ for bank loans and $7\mathrm{.}75\%$ for bond issuance in the following content?"

Date: January $2021$

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 prefeed 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.

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 $35\%$ tax rate, is $8(1-0\mathrm{.}35)=5\mathrm{.}2\%.$

The rate of return on preferred stock is $6\%.$ Sea Shore Salt pays a $$6$ dividend on each $$100$ preferred share.

Our target rate of return on equity has been $16\%$ for many years. I know that some newcomers think this target is too high

for the safe and mature salt business. But we must all aspire to superior profitability.

Once this background is absorbed$,$ the calculation of Sea Shore Salt's weighed$-$average cost of capital $($WACC$)$ is

elementary:

WACC $=8^{**}(1-0\mathrm{.}35{)}^{**}0\mathrm{.}20+7\mathrm{.}75\%**(1-0\mathrm{.}35{)}^{**}0\mathrm{.}133+6^{**}0\mathrm{.}167+{16}^{**}0\mathrm{.}5=10\mathrm{.}7\%$

The official corporate hurdle rate is$,$ therefore, $10\mathrm{.}7\%.$

If you have further questions about these calculations, please direct them to your new Treasure Analyst, Ms$.$ Bernice

Mountaindog. It is a pleasure to have Bernice back at Seat Shore Salt after a year's leave of absence to complete her

degree in Finance.

Table $1.2020$ Sea Shore Salt's Balance Sheet $($in millions$)$

Minicase Questions

Is Mr$.$ Brinepool's cost of equity correct? If not, what is the cost of equity of Sea Shore Salt?

Is Mr$.$ Brinepool's cost of preferred stock correct? If not, what is the cost of preferred stock of Sea Shore Salt?

Estimate and Weighted Average Cost of Capital $($WACC$)$ for Sea Shore Salt and explain your calculations.