Mini Case Study

Bernice Mountaindog was glad to be back at Sea Shore Salt. Employees were treated well. When she had asked a year ago for a leave of absence to complete her degree in finance, top management promptly agreed. When she returned with an honors degree, she was promoted from administrative assistant (she had been secretary to Joe-Bob Brinepool, the president) to treasury analyst.

Bernice thought the companys prospects were good. Sure, table salt was a mature business, but Sea Shore Salt had grown

steadily at the expense of its less well known competitors. The companys brand name was an important advantage, despite the difficulty most customers had in pronouncing it rapidly.

Bernice started work on January 2, 2018. The first 2 weeks went smoothly. Then Mr. Brinepools cost of capital memo (see Figure 13.2) assigned her to explain Sea Shore Salts weighted-average cost of capital to other managers. The memo came as a surprise to Bernice, so she stayed late to prepare for the questions that would surely come the next day.

Bernice first examined Sea Shore Salts most recent balance sheet, summarized in Table 13.6. Then she jotted down the following additional points:

• The companys bank charged interest at current market rates, and the long-term debt had just been issued. Book and market values could not differ by much
• But the preferred stock had been issued 35 years ago, when interest rates were much lower. The preferred stock, originally issued at a book value of $100 per share, was now trading for only $70 per share.
• The common stock traded for $40 per share. Next years earnings per share would be about $4 and dividends per share probably $2. (Ten million shares of common stock are outstanding.) Sea Shore Salt had traditionally paid out 50% of earnings as dividends and plowed back the rest.
• Earnings and dividends had grown steadily at 6% to 7% per year, in line with the companys sustainable growth rate:

Sustainable growth rate = return on equity * Plowback ratio

= 4/30*.5

= 0.067 or 6.7%

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 companys 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 companys 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 Salts financing.

	Amount (In Millions)	Percent of Total	Rate of Return
Bank Loan	$120	20.00%	8%
Bond Issue	80	13.30%	7.75%
Preferred Stock	100	16.70%	6%
Common Stock	300	50.00%	16%
total	600	100%

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%.

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 Salts weighted-average cost of capital (WACC) is elementary:

WACC = 8 (1 - .21) (.20) + 7.75 (1 - .21) (.133) + 6 (.167) + 16 (.50) = 11.1%

The official corporate hurdle rate is therefore 11.1%.

If you have further questions about these calculations, please direct them to our new Treasury Analyst, Ms. Bernice Mountaindog. It is a pleasure to have Bernice back at Sea Shore Salt after a years leave of absence to complete her degree in finance.

Table 13.6

Sea Shore Salts balance sheet, taken from the companys 2017 balance sheet (figures in $millions)

Assets		Liablilities and Net worth
Working Capital	$200	Bank loan	120
Plant and equipment	360	Long-term debt	80
other assets	40	Preferred stock	100
total	600	Common stock, Including retained earnings	300
		Total	600

Notes:

1. At year-end 2017, Sea Shore Salt had 10 million common shares outstanding.

2. The company had also issued 1 million preferred shares with book value of $100 per share. Each share receives an annual dividend of $6.

Sea Shore Salts beta had averaged about .5, which made sense, Bernice thought, for a stable, steady-growth business. She made a quick cost of equity calculation by using the capital asset pricing model (CAPM). With current interest rates of about 7%, and a market risk premium of 7%,

CAPM cost of equity = rE = rf + (rm rf )

= 7% + .5(7%) = 10.5%

This cost of equity was significantly less than the 16% decreed in Mr. Brinepools memo. Bernice scanned her notes apprehensively. What if Mr. Brinepools cost of equity was wrong? Was there some other way to estimate the cost of equity as a check on the CAPM calculation? Could there be other errors in his calculations?

Bernice resolved to complete her analysis that night. If necessary, she would try to speak with Mr. Brinepool when he arrived at his office the next morning. Her job was not just finding the right number. She also had to figure out how to explain it all to Mr. Brinepool.