HW question 2 or 3
CASE 39 Wyoming Energy Development, Inc. Cost of Capital In May 1991, Linda Bellich, a recent M.B A graduate and newly appointed assistant to the comptroller of Wyoming Energy Development, Inc (WED). was given a list of six new investment projects proposed for the following year. It was her job to analyze these projects and be prepared to present her findings before the board of directors at its annual meeting to be held in 10 days. Wyoming Energy Development was founded in Laramie, Wyoming, in 1963 by Scott Heywood. WED gained recognition as a leading producer of high-quality coal, with the majority of its sales being made to Japan. During the rapid economic expansion of Japan in the 1960s, demand for coal and other energy products boomed, and WED's sales grew rapidly As a result of this rapid growth and recognition of new opportunities in the energy market, WED began to diversify its product line While retaining its emphasis on coal production, it expanded operations to include ura- nium mining and the production of electrical generators, and finally, it went into all phases of energy production By 1990. WED's sales had reached the $140 million level, with net profit after taxes attaining a record $6.7 million As WED expanded its product line in the early 1980s, it also formal- ized its capital budgeting procedure Until 1982, capital investment projects were selected primarily on the basis of the average return on investment 218 Wyoming Energy Development, Inc 219 calculations, with individual departments submitting these calculations for projects falling within their division. In 1986, this procedure was replaced by one using present value as the decision-making criterion. This change was made to incorporate cash flows rather than accounting profits into the decision-making analysis, in addition to adjusting these flows for the time value of money. At that time, the cost of capital for WED was determined - tg a of to be 4 36 percent, which has been used as the discount rate for the past costs WED had incurred in raising funds from the capital markets over the previous 10 years. It had originally been Bellich's assignment to update this rate over the most recent 10-year period and determine the net present value of all the proposed investment opportunities using this newly calculated figure However, she objected to this procedure, stating that while this calculation gave a good estimate of the past cost of capital, changing interest rates and stock prices made this calculation of little value in the present. Bellich suggested that current costs of raising funds in the capital markets be weighted by their percentage makeup of the capital structure. This -+0.06 pro- posal was reviewed enthusiastically by the comptroller of WED, and Bellich was given the assignment of recalculating WED's cost of capital and provid- ing a written report for the financial board of directors explaining and justifying this calculation. To determine a weighted average cost of capital for WED, it was nec- essary for Linda Bellich to examine the costs associated with each source of funding used. In the past, the largest sources of funding had been the issuance of new common stock and internally generated funds Through conversations with the comptroller and other members of the board of di- rectors, Bellich learned that the firm, in fact, wished to maintain its current financial structure since it is in accordance with the book value weights shown in Exhibit 1 She further determined that the strong growth pat- terns that WED had exhibited over the past 10 years were expected to con- tinue indefinitely because of the dwindling supply of US and Japanese domestic oil and the growing importance of, and US and Japanese de- pendence on, coal and other alternative energy resources. Through fur- ther investigation, Bellich learned that WED could issue additional shares of common stock, which had a par value of $25 per share and were selling at a current market price of $45 The expected dividend for the next pe- riod would be $2 per share, with expected growth at a rate of 6 percent per year for the foreseeable future The underwriting commission paid to WED's investment banker would amount to $2 per share and would be for insuring the issue against the risk of adverse market fluctuations in the stock's selling price during the distribution process, in addition to perform- ing the function of actually selling the security and providing advice as to the timing and pricing of the issue 220 CAMIAI INVESTMENT DECISIONS EXHIBIT 1 Wyoming Energy Development, Inc. Balance Sheet for Year Ending April 30, 1991 Aunt 1991 Cash $ 9,000,000 Accounts receivable $1,000,000 Inventories 12,000,000 Total current assets $ 52,000,000 Net fixed assets 195,000,000 Goodwill 7,000,000 Total assets $252,000,000 Lisbilities and Equity Accounts payable Current debt Rccrued taxes Total current liabilities Long-term debt Preferred stock Common stock Retained earning Toual liabilities and equity $ 850,000 10.000.000 1,150,000 $ 12,000,000 72.000.000 43.000.000 114,000,000 11.000.000 $252,000,000 40 6.397 Preferred stock at 6 percent also could be issued with the help of an investment banker at $97 per share with a par value of $100 per share of this $97, 3.1 percent would go to the investment banker for his help in marketing the issue with the remainder of the funds going to WED Finally, Bellich learned that it would be possible for WED to raise an additional $1 million through a one-year loan from WED's Chicago bank at 9 percent. Any amount raised over $1 million would cost WED 14 per- cent. Short-term debt has always been used by Wyoming to finance capital expenditures, and as WED grows, it is expected to maintain its proportion in the capital structure to support capital expansion Also, $6 million could be raised through a bond issue with 30 years' maturity with a 10 percent coupon at 98 percent of face value on this issue, 2 percent of the face value would be charged as an underwriting commission If it became nec- essary to raise more funds via long-term debt, $3 million more could be accumulated through the issuance of additional 30-year bonds sold at 95 percent of face value, with the coupon rate being raised to 11 percent and 2 percent of the face value being charged as an underwriting commission While any additional funds raised via long-term debt would necessarily 1 480 1.40 Wyoming Energy Development, Inc 221 have a 30-year maturity with a 14 percent coupon yield and be sold at 95 percent of face value, 2 percent of this face value would be charged as an underwriting fee. Here again, this fee would go to the investment banker for his help in marketing the issue. In the past, WED has calculated a weighted average of these sources of funds to determine its cost of capital. In discussions with the current comptroller, the point was raised that while this served as an appropriate calculation for externally generated funds, it did not take into account the fact that much of the funds used for capital expenditures by WED were internally generated. For example, WED is expected to produce $5 million in depreciation-generated funds in addition to retaining S4 million of its earnings during the coming period. The comptroller agreed that there should be some cost associated with retained earnings financing incorpo- rated into the calculations, but depreciation charges should not be included since they, as opposed to all other financing methods, do not appear on the liability side of the balance sheet Although Bellich was not completely con- vinced by the comptroller's logic, she continued with her work 2. Compute company's weighted average cost of capital (WACC), if they need to raise $25 million in new funds. 3. Compute company's cost of capital if they need to raise $40 million in new funds. CASE 39 Wyoming Energy Development, Inc. Cost of Capital In May 1991, Linda Bellich, a recent M.B A graduate and newly appointed assistant to the comptroller of Wyoming Energy Development, Inc (WED). was given a list of six new investment projects proposed for the following year. It was her job to analyze these projects and be prepared to present her findings before the board of directors at its annual meeting to be held in 10 days. Wyoming Energy Development was founded in Laramie, Wyoming, in 1963 by Scott Heywood. WED gained recognition as a leading producer of high-quality coal, with the majority of its sales being made to Japan. During the rapid economic expansion of Japan in the 1960s, demand for coal and other energy products boomed, and WED's sales grew rapidly As a result of this rapid growth and recognition of new opportunities in the energy market, WED began to diversify its product line While retaining its emphasis on coal production, it expanded operations to include ura- nium mining and the production of electrical generators, and finally, it went into all phases of energy production By 1990. WED's sales had reached the $140 million level, with net profit after taxes attaining a record $6.7 million As WED expanded its product line in the early 1980s, it also formal- ized its capital budgeting procedure Until 1982, capital investment projects were selected primarily on the basis of the average return on investment 218 Wyoming Energy Development, Inc 219 calculations, with individual departments submitting these calculations for projects falling within their division. In 1986, this procedure was replaced by one using present value as the decision-making criterion. This change was made to incorporate cash flows rather than accounting profits into the decision-making analysis, in addition to adjusting these flows for the time value of money. At that time, the cost of capital for WED was determined - tg a of to be 4 36 percent, which has been used as the discount rate for the past costs WED had incurred in raising funds from the capital markets over the previous 10 years. It had originally been Bellich's assignment to update this rate over the most recent 10-year period and determine the net present value of all the proposed investment opportunities using this newly calculated figure However, she objected to this procedure, stating that while this calculation gave a good estimate of the past cost of capital, changing interest rates and stock prices made this calculation of little value in the present. Bellich suggested that current costs of raising funds in the capital markets be weighted by their percentage makeup of the capital structure. This -+0.06 pro- posal was reviewed enthusiastically by the comptroller of WED, and Bellich was given the assignment of recalculating WED's cost of capital and provid- ing a written report for the financial board of directors explaining and justifying this calculation. To determine a weighted average cost of capital for WED, it was nec- essary for Linda Bellich to examine the costs associated with each source of funding used. In the past, the largest sources of funding had been the issuance of new common stock and internally generated funds Through conversations with the comptroller and other members of the board of di- rectors, Bellich learned that the firm, in fact, wished to maintain its current financial structure since it is in accordance with the book value weights shown in Exhibit 1 She further determined that the strong growth pat- terns that WED had exhibited over the past 10 years were expected to con- tinue indefinitely because of the dwindling supply of US and Japanese domestic oil and the growing importance of, and US and Japanese de- pendence on, coal and other alternative energy resources. Through fur- ther investigation, Bellich learned that WED could issue additional shares of common stock, which had a par value of $25 per share and were selling at a current market price of $45 The expected dividend for the next pe- riod would be $2 per share, with expected growth at a rate of 6 percent per year for the foreseeable future The underwriting commission paid to WED's investment banker would amount to $2 per share and would be for insuring the issue against the risk of adverse market fluctuations in the stock's selling price during the distribution process, in addition to perform- ing the function of actually selling the security and providing advice as to the timing and pricing of the issue 220 CAMIAI INVESTMENT DECISIONS EXHIBIT 1 Wyoming Energy Development, Inc. Balance Sheet for Year Ending April 30, 1991 Aunt 1991 Cash $ 9,000,000 Accounts receivable $1,000,000 Inventories 12,000,000 Total current assets $ 52,000,000 Net fixed assets 195,000,000 Goodwill 7,000,000 Total assets $252,000,000 Lisbilities and Equity Accounts payable Current debt Rccrued taxes Total current liabilities Long-term debt Preferred stock Common stock Retained earning Toual liabilities and equity $ 850,000 10.000.000 1,150,000 $ 12,000,000 72.000.000 43.000.000 114,000,000 11.000.000 $252,000,000 40 6.397 Preferred stock at 6 percent also could be issued with the help of an investment banker at $97 per share with a par value of $100 per share of this $97, 3.1 percent would go to the investment banker for his help in marketing the issue with the remainder of the funds going to WED Finally, Bellich learned that it would be possible for WED to raise an additional $1 million through a one-year loan from WED's Chicago bank at 9 percent. Any amount raised over $1 million would cost WED 14 per- cent. Short-term debt has always been used by Wyoming to finance capital expenditures, and as WED grows, it is expected to maintain its proportion in the capital structure to support capital expansion Also, $6 million could be raised through a bond issue with 30 years' maturity with a 10 percent coupon at 98 percent of face value on this issue, 2 percent of the face value would be charged as an underwriting commission If it became nec- essary to raise more funds via long-term debt, $3 million more could be accumulated through the issuance of additional 30-year bonds sold at 95 percent of face value, with the coupon rate being raised to 11 percent and 2 percent of the face value being charged as an underwriting commission While any additional funds raised via long-term debt would necessarily 1 480 1.40 Wyoming Energy Development, Inc 221 have a 30-year maturity with a 14 percent coupon yield and be sold at 95 percent of face value, 2 percent of this face value would be charged as an underwriting fee. Here again, this fee would go to the investment banker for his help in marketing the issue. In the past, WED has calculated a weighted average of these sources of funds to determine its cost of capital. In discussions with the current comptroller, the point was raised that while this served as an appropriate calculation for externally generated funds, it did not take into account the fact that much of the funds used for capital expenditures by WED were internally generated. For example, WED is expected to produce $5 million in depreciation-generated funds in addition to retaining S4 million of its earnings during the coming period. The comptroller agreed that there should be some cost associated with retained earnings financing incorpo- rated into the calculations, but depreciation charges should not be included since they, as opposed to all other financing methods, do not appear on the liability side of the balance sheet Although Bellich was not completely con- vinced by the comptroller's logic, she continued with her work 2. Compute company's weighted average cost of capital (WACC), if they need to raise $25 million in new funds. 3. Compute company's cost of capital if they need to raise $40 million in new funds
