Risk Management and Corporate Capital Costs COBA Corporation After the meeting. Tiffin and Bergerson were feeling some relief and some apprehension over the way things went. They were relieved because they believed that Kenner now fully understood why they made financial decisions in such a manner. In addition, the more experienced financial staff from each of the divisions were also "tuned in." Their apprehension arose, however, from a series of questions raised by Kara Sims, a finance major and summer intern from a nearby university. Sims' questions seemed to imply that COBA's approach to cost of capital calculations was less than up-to-date. The young summer intern was especially interested in Tiffin and Bergerson's views concerning the book versus market cost of capital. For example. how did these differ and did the difference, if any, influence the manner in which capital budgeting was conducted, or the results which were obtained? In other words. Ms. Sims wanted to make clear the following points: (1) The dividend model had some inherent shortcomings, and (2) Capital investment decisions, the primary use for the cost of capital. should be made with regard to marginal cost as well as marginal revenue. These issues and concerns were not new to Tiffin and Bergerson. They were sure that each of Sims' points was relevant. and they decided that all matters concerning the cost of capital had to be cleared up immediately. Only then could it be decided whether another meeting with Kenner and the divisional finance and accounting staff was warranted. In order to resolve things in the most efficient manner possible, a special project was designed for Sims. In essence, Tiffin and Bergerson wanted Sims to design a cost of capital manual for use by COBA management. The issues to be dealt with in the manual were those alluded to by Sims earlier. These could be enumerated as follows: 1. Explain the difference between book value cost of capital and market value cost of capital. 2. 3. 4. Discuss an alternative to the dividend model of use in calculating the cost of equity. Specifically outline, in clear detail, the Capital Asset Pricing Model (CAPM) approach to the cost of equity. Concerning Item 2, describe the sources for the parameters of the CAPM or its relevant component, the Security Market Line (SML). What effect, if any, will any changes to the cost of capital calculation have upon the firm's capital budgeting activities and the number and type of projects it ultimately accepts? The issues that Sims wanted to clarify for the company would influence the policy set by the firm concerning financial matters. As a result, the firm's strategy would also be influenced. The proper considerations of risk in capital budgeting was important; it was also multifaceted. Sims wanted a clear, cohesive set of guidelines for the firm to follow. The cost of capital for the firm was influenced by the cost of capital for the two divisions. Each division's cost of capital would, in a CAPM setting, be based upon the particular characteristics of the individual division. The idea and practice of comparing an operating division to a firm which operates solely in that line of business was known as the "pure-play" technique. Therefore, the debt level of a division's pure- play, and the cost of debt which resulted from that debt level, helped to determine the division's cost of capital. In general, the greater the debt level of a division, the greater the division's beta coefficient. (Beta measures the nondiversifiable risk of a security, such as a company's stock, or an operating division of a company.) Sims began work on the assignment immediately. She believed that a thorough job would be good for the progressive and well-run company and would also assure her a more permanent position them. As a result of these motivations. Sims wanted to be as systematic as possible in her task. As a first step she wanted to recast the company's balance sheet, shown in Table I, in the most current manner possible. It was clear to Sims that the long-term capital items in the capital structure would appear differently if 2