Introduction

SoCal Semiconductor (SCS) was founded in Irvine, California, in 1985 by a team of engineers led by Joe Reed. Reed took early retirement that year from his position as an engineering professor at a major Southern California university. During his years at the university, Reed was actively involved in semiconductor research, and he was a consultant to several firms in the industry.

SCS started with a $500,000 investment from its founders and a $4.5 million design contract from a leading cellular telephone company. SCS soon parlayed its scientific skills and Reeds familiarity with the industry into a thriving business, and in 1989 the company built a state-of-the-art manufacturing plant at a cost of $100 million. The necessary capital was obtained from venture capitalists and commercial banks. SCS has since produced and marketed a broad range of computer chips for commercial use in the semiconductor market, primarily to makers of cellular telephones and laptop computers. Continued innovation in its memory and logic products, along with a rapid expansion of the markets for these products, has resulted in high profitability and very rapid growth. By 1990, SCSs growing capital needs could no longer be met by internal funds, venture capital and its ability to borrow, so the company went public. Currently, SCS shares trade in the over-the-counter market, and they have been selling at about $22 per share.

The Problem

Since the companys inception, Joe Reed has been directly and tirelessly involved in all facets of the business. He is satisfied with the product development, manufacturing, and marketing aspects of the business, and he is quite comfortable with his ability to evaluate and guide these activities. However, he has become increasingly uneasy about the finance function, in which he has no special expertise. With the rapid growth in the scope and size of the business, financial decisions have become increasingly complex. Furthermore, competition in the lucrative cellular telephone market from well-established firms has also been increasing. By 1997, Reed realized that, to ensure continued success, he had to establish a finance group that was as competent and sophisticated as those of his competitors. Therefore, in late 1997, he hired George Kennedy, a senior financial executive of a competing firm, to head the finance group at SCS.

Kennedys first task was to review the existing capital investment procedures and to report his findings and recommendations to SCSs board of directors. In going over the procedures manuals and the supporting analyses for recent capital investment decision, Kennedy quickly saw that the overall procedures were generally appropriate: the firm relied primarily on the Net Present Value technique to arrive at accept/reject decisions for most projects; it estimated future cash flows on an incremental basis; and it discounted cash flows at the firms weighted average cost of capital. However, the cost of capital estimation technique was questionable. In the most recent capital budgeting exercise, at the year-end 1996, the treasurer used a before-tax cost of debt of 9.5 percent, which was equal to the coupon rate on the most recent (1994) long-term debt issue. The bond rating in 1996, as in 1994, was A. For the cost of equity, the treasurer used the year-end earnings yield (E/P) of 12.27 percent, based on earnings per share of $2.70 and a share price of $22.

The Analysis

Just before the winter holidays, the treasurer resigned, and Kennedy turned to Mary Porter, a recently hired MBA from the Pepperdine University On-line MBA Program, to conduct a complete cost-of-capital analysis as of year-end 1997, and also to provide a critical evaluation of the current estimation procedure. As part of the cost-of-capital analysis, Kennedy asked Porter to examine the current capital structure to see if it approached the optimal capital structure.

TABLE 1

SoCal Semiconductor, Inc. Balance Sheet

For the Year Ended December 31, 1997

(In Millions of Dollars)

Cash and securities $ 15.3 Accounts payable $ 8.0

Accounts receivable 50.2 Accurals 8.6

Inventory 30.6 Notes payable 3.5

Current assets 96.1 Current liabilities 20.1

Net fixed assets 200.5 Long-term debt 55.6

Common stock 97.2

Retained earnings 123.7

Total assets $296.6 Total claims $296.6

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Porter first reviewed the 1997 balance sheet, which is summarized in Table 1. Next, she assembled the following data:

The bond quote on SCSs long-term, semi-annual bonds maturing in 15 years as reported in the financial press is as follows:

Bond Cur Yld Vol Close Net Chg

SCS 9 9.9 28 95 +1/8

Quotes on long-term Treasury bonds were obtained from the financial pages of the local newspaper:

Coupon Maturity Bid Ask Chg Ask Yld

6 5/8 Dec. 07 92.27 92.29 -2 7.67

8 7/8 Dec. 17 109.02 109.05 +1 7.96

8 Dec. 27 99.11 99.14 -1 8.30

Quotes on Treasury bills were also obtained from the financial pages:

Maturity Days to Mat Bid Ask Chg Ask Yld

Mar 31 91 5.23 5.19 -.02 5.34

June 26 178 5.48 5.46 +.04 5.69

Sep 29 273 5.61 5.59 -.03 5.92

SCSs federal-plus-state tax rate is 40 percent.

Quotes on SCSs 4.5 million shares of common stock were as follows:

52 weeks Prior day

Hi Low Stock Div Y/D PE Vol (100s) Hi Low Close Chg

23 19 3/8 SCS 1.0 4.4 7.5 356 22 22 22 +1/4

A prominent investment banking firm recently estimated that the market risk premium is 6 percentage points over Treasury rates. SCSs historical beta, as measured by several analysts who follow the stock, is 1.25.

The average flotation cost on newly issued equity for a firm of SCSs risk is 0.5 percent.

The current market value (the current price per security multiplied by the number of securities outstanding) of the capital structure is a close proxy for the firms long-term target capital structure (round market values to match debt structures below). SCSs only permanent sources of funds are long-term debt and equity.

Current before cost of debt for firms similar to SCS is all ways except their capital structure is:

% Debt Interest rate

10% 9.5%

20% 10%

30% 11%

40% 12%

50% 16%

60% 18%

70% 19%

HOW TO CALCULATE WACC??