Palo Alto Semiconductor (PAS) was founded in Palo Alto, California, in 1994 by a team of engineers led by Frank Davies. Davies took early retirement that year from his position as an engineering professor at a major West Coast university. During his tenure at the university, Davies was actively involved in semiconductor research, and he was a consultant to several firms in the industry.

PAS started with a $500,000 investment from its founders and a $4.5 million design contract from a leading cellular telephone company. PAS soon parlayed its scientific skills and Davies' familiarity with the industry into a thriving business, and in 1997 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. PAS 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 in the market for these products, has resulted in high profitability and very rapid growth. By 1999, PAS's growing capital needs could no longer be met by internal funds, venture capital, and its ability to borrow, so the company went public. Currently, PAS shares trade in the over-the-counter market, and they have been selling at about $22 per share.

Since the company's inception, Frank Davies 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. Further, competition in the lucrative cellular telephone market from such established firms as Texas Instruments, Intel, and National Semiconductor has also been increasing. By 2005 Davies 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 2005, he hired Thomas Johnson, a senior financial executive of a competing firm, to head the finance group at PAS.

Johnson's first task was to review the existing capital investment procedures and to report his findings and recommendations to PAS's board of directors. In going over the procedures manuals and the supporting analyses for recent capital investment decisions, Johnson quickly saw that the overall procedures were generally appropriate: The firm relied primarily on the Net Present Value criterion 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 firm's weighted average cost of capital. However, the cost of capital estimation techniques was questionable. In the most recent capital budgeting exercise, at year-end 2004, the treasurer used a before-tax debt cost of 9.5%, which was equal to the coupon rate on the most recent (2002) long-term bond issue. The bond rating in 2004, as in 2002, was A. For the cost of equity, the treasurer used the year-end earnings yield (E/P) of 12.27%, based on an earnings per share of $2.70 and a share price of $22.

Just before the winter holidays, the treasurer resigned, and Johnson called upon Jane Cable, a recently hired MBA from UC-Berkeley, to conduct a complete cost-of-capital analysis as of yearend 2005, and also to provide a critical evaluation of the current estimation procedures.

TABLE 1

Palo Alto Semiconductor, Inc.: Balance Sheet

for the Year Ended December 31, 2005

(In Millions of Dollars)

Cash and securities $ 15.3

Accounts payable $ 8.0

Accounts receivable 50.2

Accruals 8.6

Inventory 10.6

Notes Payable 3.5

Current Assets $ 76.1

Current liabilities $ 20.1

Net fixed assets 220.5

Long-term debt 98.2

Preferred stock 35.6

Common stock 40.0

Retained earnings 102.7

Total assets $296.6

Total claims $ 296.6

Cable first reviewed the 2005 balance sheet, which is summarized in Table 1. Next, she assembled the following data:

(1) The bond quote on PAS's long-term, semi-annual bond as reported in the financial press is as follows:

Bonds CurYld Vol Close Net Chg

PAS 9 s 25 9.9 28 95 +

(2) Quotes on PAS's common and preferred stock were as follows:

52 weeks y/d Vol Net

Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

23 19 PAS PASA 1.0 4.4 7.5 356 22 22 22 +

108 100 PASpf - 9.0 8.6 87 104 103 104 -

(3a) Quotes on long-term Treasury bonds were obtained from The Wall Street Journal:

Coupon Maturity

Rate Mo./ Yr. Bid Asked Chg Ask Yld

6 Dec. 15 92:27 92:29 -2 7.76

8 Dec. 25 109:02 109:05 +1 7.96

8 Dec. 35 99:11 99:14 -1 8.33

(3b) Quotes on Treasury bills were also obtained from The Wall Street Journal:

Days to Maturity Mat. Bid Asked Chg AskYld

Mar 31 91 5.23 5.19 -.02 5.34

Jun 26 178 5.48 5.46 +.04 5.69

Sep 29 273 5.61 5.59 -.03 5.92

(4) PAS's federal-plus-state tax rate is 40 percent.

(5) The firm's last dividend (DO) was $1.00, and recent dividends have been growing at a rate of about 10.5 percent. Some analysts expect the recent growth rate to continue, while others expect it to go to zero as new competition enters the market, but the majority anticipate a growth rate of about 10 percent for the indefinite future. The company has 8.0 million common shares outstanding.

(6) A prominent investment banking firm recently estimated that the market risk premium is 6 percentage points over Treasury bonds. PAS's historical beta, as measured by several analysts who follow the stock, is 1.1.

(7) The going interest rate on average A-rated long-term bonds is 10.0 percent.

(8) PAS is forecasting earnings of $26,400,000 and depreciation of $6,000,000 for the coming year. About one-third of earnings will be paid out as dividends.

(9) PAS's investment bankers believe that a new issue of common stock would involve total flotation costs-including underwriting costs, market pressure from increased supply, and market pressure from negative signaling effects-of 30 percent. Preferred stock would have a flotation cost of $2 per share.

(10) The market value target capital structure calls for 20 percent long-term debt, 10 percent preferred stock, and 70 percent common equity.

(11) PAS's return on equity (ROE) has averaged 14.5 percent over the past five years, and the company has paid out, on average, about 33 percent of its net income as dividends.

(12) The firm's dividends per share over the past five years have been as follows:

Year Dividend

2001 $0.68

2002 0.75

2003 0.85

2004 0.95

2005 1.00

Jane Cable must critique PAS's current procedures for estimating the costs of debt and equity, and then she must use the data, along with methods she learned in school, to estimate PAS's component costs of capital, weighted average cost of capital, and marginal cost of capital schedule. She must also decide whether it is appropriate to use her estimate of the marginal weighted average cost of capital as the hurdle/discount rate for all the firm's projects. Jane is also curious about what the cost of preferred stock would be if it had a mandatory redemption provision specifying that the firm must redeem the issue in five years at a price of $110 per share.

Your assignment is to work with Jane on her report. If Johnson likes the report -that is, if he thinks it is logical, technically correct, and well presented-he will send copies to President Davies and other members of PASs executive committee. That will give your career-and Jane's-a big boost.

1

The company uses the earnings yield as a measure of the firm's cost of equity. Is this acceptable?

2

What should the firm do with floatation costs on the debt? What is commonly accepted? Why?

3

Their current debt matures in 20 years. Is it acceptable to use the cost of a 20 year debt instrument to estimate the cost of a 30 year debt instrument? Under what conditions are they the same?

4

In calculating the cost of equity under the CAPM, what risk free rate should be used? T-Bill? T-Bond? If T-Bond, then which one? Which one does the finance literature support? Which one does your group favor?

5

There is more than one way to estimate growth (i.e., "g" in the constant growth model.) What ways can you come up with?

6

There is more than one way to calculate the cost of equity capital. What are they? Which is favored in the literature?

7

A firm might be able to issue $200 million in new debt at one price, but if they issued more, the price may go up. This affects what is known as the MCC (marginal cost of capital). This problem talks about the MCC, but it does not say anything about debt prices changing. What do we need to know MCC for?

Looking for any ideas to solve the Case study. Thank you!

Questions

1. The company uses the earnings yield as a measure of the firm's cost of equity. Is this acceptable?

2. What should the firm do with floatation costs on the debt? What is commonly accepted? Why?

3. Their current debt matures in 20 years. Is it acceptable to use the cost of a 20 year debt instrument to estimate the cost of a 30 year debt instrument? Under what conditions are they the same?

4. In calculating the cost of equity under the CAPM, what risk free rate should be used? T-Bill? T-Bond? If T-Bond, then which one? Which one does the finance literature support? Which one does your group favor?

5. There is more than one way to estimate growth (i.e., "g" in the constant growth model.) What ways can you come up with?

6. There is more than one way to calculate the cost of equity capital. What are they? Which is favored in the literature?

7. A firm might be able to issue $200 million in new debt at one price, but if they issued more, the price may go up. This affects what is known as the MCC (marginal cost of capital). This problem talks about the MCC, but it does not say anything about debt prices changing. What do we need to know MCC for?