MINICASE 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 man- agement 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 company's 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 company's brand name was an important advantage, despite the difficulty most customers had in pronouncing it rapidly. Bernice started work on January 2, 2011. The first 2 weeks went smoothly. Then Mr. Brinepool's cost of capital memo (see Figure 13.2) assigned her to explain Sea Shore Salt's weighted- average cost of capital to other managers. The memo carne as a surprise to Bernice, so she stayed late to prepare for the questions that would surely come the next day. Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 13.2 Mr. Brinepool's cost of capital memo Sea Shore Salt Company Spring Vacation Beach, Florida CONFIDENTIAL MEMORANDUM January 15, 2011 S . S . S. Management Joe-Bob Brinepool, President Cost of Capital is memo states and clarifies our company's long-standing policy regarding hurdle ates for capital investment decisions. There have been many recent questions, and orne evident confusion, on this matter. ea Shore Salt evaluates replacement and expansion investments by discounted cash low. The discount or hurdle rate is the company's after-tax weighted-average cost f capital. e weighted-average cost of capital is simply a blend of the rates of return ected by investors in our company. These investors include banks, bondholders, d preferred stock investors in addition to common stockholders. Of course many of u are, or soon will be, stockholders of our company. e following table summarizes the composition of Sea Shore Salt's financing. Amount (in millions) Percent of Total Rate of Return $120 20% 8% 80 13.3 7.75 100 16.7 6 300 50 16 -- -- $600 100% e rates of return on the bank loan and bond issue are of course just the terest rates we pay. However, interest is tax-deductible, so the after-tax terest rates are lower than shown above. For example, the after-tax cost of our financing, given our 35% tax rate, is 8(1 - .35) = 5.2%. e rate of return on preferred stock is 6%. Sea Shore Salt pays a $6 dividend on ch $100 preferred share. r target rate of return on equity has been 16% for many years. I know that some comers think this target is too high for the safe and mature salt business. But must all aspire to superior profitability. ce this background is absorbed, the calculation of Sea Shore Salt's ighted-average cost of capital (WACC) is elementary; WACC = 8 (1 - . 3 5) ( . 2 0 ) + 7. 75 (1 - . 3 5) ( . 13 3) + 6 ( . 167 ) + 16 ( . 50 ) 10.7% e official corporate hurdle rate is therefore 10.7%. f you have further questions about these calculations, please direct them to our Treasury Analyst, Ms. Bernice Mountaindog. It is a pleasure to have Bernice ck at Sea Shore Salt after a year's leave of absence to complete her degree in 395 396 Part Three Risk Bernice first examined Sea Shore Salt's most recent balance sheet, summarized in Table 13.6. Then she jotted down the follow- ing additional points: The company's 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 year's earnings per share would be about $4 and dividends per share probably $2. (10 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 company's sustainable growth rate: Sustainable _ return plow back growth rate - on equity X ratio = 4/30 X .5 = .067, or 6.7% TABLE 13.6 Sea Shore SaWs balance sheet. taken from the company' 201 0 balance sheet (figures in millions) Working capital Plant and equipment Other assets Total $600 Sea Shore Salt's 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 + j3(r m - rf) = 7% + .5(7%) = 10.5% This cost of equity was significantly less than the 16% decreed in Mr. Brinepool's memo. Bernice scanned her notes apprehen- sively. What if Mr. Brinepool's 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 neces- sary, 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. $200 360 40 Bank loan Long-term debt Preferred stock Common stock, including retained earnings Total $120 80 100 300 $600 Notes: At year-end 2010, Sea Shore Salt had 10 million common shares outstanding. The company had also issued 1 million preferred shares with book value of $100 per share. Each share receives an annual dividend of $6. 18.4 a. This question is answered by the planning model. Given assumptions for asset growth, the model will show the need for external financing, and this value can be compared to the firm's plans for such financing. Such a relationship may be assumed and built into the model. However, the model does not help to determine whether it is a reasonable assumption. Financial models do not shed light on the best capital structure. They can tell us only whether contemplated financing decisions are consistent with asset growth. 18.5 a. The equity-to-asset ratio is .8. If the payout ratio were reduced to 25%, the maximum growth rate assuming no external financing would be .75 X 18% X .8 = 10.8%. If the firm also can issue enough debt to maintain its equity-to-asset ratio unchanged, the sustainable growth rate will be .75 X 18% = 13.5%. Chapter 18 Long-Term Financial Planning