Risk Management and Corporate Capital Costs COBA Corporation Ifter 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 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 Bergersons views concerning the book versus market cost 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. Vs. Sims wanted to make clear the following points: (1) The dividend model had some inherent shortcomings, and (2) Capital investment decisions. the primary use the cost of capital should be made xwith regard to marginal cost as well as marginal revenue. These issues and concerns were not new to Tiftin Bergerson. They were sure that cach 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 cand 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 carlier. These could be enumerated as follows: 1. Explain the difference between book value cost of capital and market value cost of capital. 2. Discuss an alternative to the dividend model of use in calculating the cost of equity. Speci outline, clear detail, the Capital Asset Pricing Model (CAPM) approach to the cost of equity 3. Concerning Item 2. describe the sources for the parameters of the CAPM or its relevant component, the Security Market Line (SML). the value of each was calculated using market weights. She knew, for instance, that debt identical to the 9 percent debt now outstanding for COBA could be issued with a 7 percent yield. The market value of the common stock was $21 at present. As a result of that information a market value capital structure would have to be calculated as a part of her task. (Recall that the firs income tax rate is 35 percent.) In addition to the capital structure explanation. Sims wanted to make sure that the delineation of the cost of equity calculations was clear. She wanted to illustrate a smooth transition from the dividend model to a more market oriented model. The capital asset pricing model which Sims' finance professor insisted was superior to internally influenced models such as the dividend model, was the analytical approach she wanted to emulate. Specifically, the individual company aspect of the CAPM known as the security market line would be used to calculate the firm's equity cost, the required yield on equity. Sims knew, for example, that the parameters for the SML included a risk-free (or, very low risk) interest rate, the return on a market average of common stock, and the firm's beta. Further, it was clear that a low risk proxy used in the SML was the return on U.S. Treasury bills. The bonds outstanding: have an assumed maturity value of $1000 and a remaining maturity of 15 years. In addition, the imbalance on the halance sheet resulting from the market value of capital would be corrected by assigning replacement value to the land, buildings and equipment The firm's bela could be calculated or simply found in one of several publications which carried financial rities and similar information. The return on the market index could be calculated or assumed to be represented by the ROE of a broad market index (such a number was approximately 12.5 percent at the end od 1992). Sims, equipped with the foregoing data and information believed she was ready to prepare an up- to-date cost of capital for the company, The return on the market calculation may be handled in at least two ways: (1) By subtracting from the historical average return on common stock the historical average return on high-grade corporate bonds and adding the difference to the currently prevailing rate on high-grade corporate bonds, or (2) A specific pool of stocks (all industrial stocks or all utility stocks) might be assessed for their level of return over some time period. In any case, the objective is to obtain as representative a figure as possible relative to the factors that influence stock returns. TABLE 1 COBA Corporation Balance Sheer December 31, 1992 (000s) 4. Total current assets 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? $800 Total current liabilities Land $8.000 Long-term debt (at 9%) Common stock $250 21.750 26,000 Buildings (net) Equipment (net) 12.200 (2m shares outstanding) Retained earnings 20,000 Total fixed assets 46.200 5.000 Total assets S47,000 Total liabilities and net worth S47.000 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 diferently if Questions 1 What is COBA's cost of equity using the SML (=CAPM)? Explain the difference between these numbers. (Assume that the risk-free rate of interest is 5 percent, and the firm's heta is 1.41), What is COBA's weighted average market value cost of capital using the information in Question above