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Case Study Three Sea Shore Salt Case Instructions: Please complete the following the case study. Once you have completed the case study, answer the questions about the case study, the questions are found in the \"Case Study Three Questions\" section of the course. In answering the questions, be sure to show all of the work that goes into your calculations. Case Study Three Instructions Sea Shore Salt Case 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 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. 73 BUSM 201: Financial Management Bernice started work on January 2. 2006. The first 2 weeks went smoothly. Then Mr. Brinepool's cost of capital memo (see Figure 12-2) assigned her to explain Sea Shore Salt's weightedaverage 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 Salt's most recent balance sheet, summarized in Table 12-6. Then she jolted down (he following 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 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. Sea Shore Salt had traditionally paid out 50 percent of earnings as dividends and plowed back the rest. Earnings and dividends had grown steadily at 6 to 7 percent per year, in line with the company's sustainable growth rate: Sustainable growth rate = return on equity 4/30 x .5 = .067,or 6.7% = x plowback ratio 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 percent, and a market risk premium of 7 percent. This cost of equity was significantly less than the 16 percent decreed in Mr. Brinepool's memo. Bernice scanned her notes apprehensively. What if Mr. Brinepool's cost of equity was wrong? Was there some other way 74 Case Study Three to estimate the cost of equity as a check on the CAPM calculation? Could there be other errors in his calculations? Table 12-6 Sea Shore Salt's balance sheet, take from the company's 2005 balance sheet (figures in millions). Assets Working capital Plant and equipment Liabilities and Net Worth $200 Bank Loan $120 Total Long-term debt 80 40 Preferred stock 100 Common stock, including retained earnings Other assets 360 300 $600 Total $600 Notes: 1. At year-end 2005, 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. Fig 12-2 Mr. Brinepool's cost of capital Memo _________________________________________________ Sea Shore Salt Company Spring Vacation Beach, Florida CONFIDENTIAL MEMORANDUM DATE: January 15, 2006 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 aftertax weighted-average cost of capital. 75 BUSM 201: Financial Management The weighted-average cost of capital is simply a blend of t he 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 Salt's financing. Amount (in millions) Bank loan Bond issue Preferred stock Common stock Percent of Total $120 80 100 300 $600 20% 13.3 16.7 50 100% Rate of Return 8% 7.75 6 16 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 aftertax 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 -.35) = 5.2%. 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 profit ability. Once this background is absorbed, the calculation of Sea Shore Salt's weighted-average cost of capital (WACC ) is elementary: WACC = 8% (1 -0.35) (0.20) + 7.75% (1 -0.35) (0.133) + 6% (0.167 ) + 16% (0. 50) = 10. 7% The official corporate hurdle rate is therefore 10.7%. 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 year's leave of absence to complete her degree in finance. ____________________________________________________ 76 Case Study Three Please answer all the questions in the\"Case Study Three Questions\" section of the course. In answering the questions, be sure to show all of the work that goes into your calculations. Questions for Sea Shore Salt Co. 1. What is Sea Shore Salt's appropriate weighted-average cost of capital? When we calculate the WACC, we will typically stick to the basic formula: and focus just on long-term debt and equity. But if preferred stock and bank loans are important sources of financing, we can easily extend this equation to include those as well: We'll use this formula for this case (P refers to preferred stock and B refers to bank debt). So your task is to find the appropriate weights (D/V, E/V, P/V, B/V) for each type of financing and the appropriate rates of return for each type of financing (rD, rE, rP, rB). When calculating rE using the CAPM, you can assume that Bernice's estimates for rf, , and (rm-rf) are correct. 2. For any corrections you make to Mr. Brinepool's estimate of the WACC, explain why Mr. Brinepool was wrong. 3. As a check on your estimate of the cost of equity (rE), also calculate the cost of equity using the dividend discount model. Does this estimate support your CAPM estimate of the cost of equity (i.e. is it reasonably close)? If not, explain why the two estimates are different. 4. Briefly interpret your WACC estimate, explaining what it means and how Sea Shore Salt would use it. 77