Sara Dylan, recently graduated with a degree in Finance, was offered a job as a treasury analyst in ABS car manufacturer. As she started her job, Sara thought the companys prospects were good. ABS was a mature business that had grown steadily at the expense of its less-well-known competitors.

Sara started work on January 2, 2018. The first 2 weeks went smoothly. Then (Saras manager) Mr. Wards cost of capital memo assigned her to explain the ABS weighted average cost of capital to other managers.

Sara first examined ABSs most recent balance sheet, summarized in Table 1. Then she made the following additional points:

Interest rates were charged at the current rate by the lenders, and the long-term debt had just been issued. There is no significant difference between the Book and market values.

The preferred stocks had been issued 35 years ago, when interest rates were much lower. Back then, the book value of the preferred stock was 100 per share, but now trading for only 70 per share.

The common stock traded for 40 per share.

Next years earnings per share would be about 4 and dividends per share probably 2. (Ten million shares of common stock are outstanding.)

ABS 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 companys sustainable growth rate:

Table 1. ABS balance sheet, taken from the company's 2017 balance sheet (figures in millions)

Notes:

1- At year-end 2017, 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.

ABSs beta had averaged about 0.5, which made sense, Sara thought, for a stable, steady-growth business. Assume the current interest rate of 7% and the market risk premium is 7%. Prepare a presentation to Mr. Ward (Saras boss); in your presentation, make sure you address the points 1-3. Remember your job is not just finding the right number, you also need to figure out how to explain it all to Mr. Ward and the mangers.

1- Find and explain the relevant cost of equity using the Capital Asset Pricing Model. In your answer, you need to make sure you explain the CAPM, the modes parameters and then interpret the models output.

2- Compare your calculation with the relevant values provided in Mr. Wards memo. Is there a difference between your calculations and the values presented in the memo? if yes then make sure you explain to the managers why you ended up with different values. Is there some other way to estimate the cost of equity as a check on the CAPM calculation? Could there be errors in Mr. Wards calculations?

3- Find and explain the weighted average cost of capital of ABS business. Compare your calculated value with those provided in the memo, and explain the difference if there is any.

ABS manufacturing

Confidential memorandum

This memo States and clarifies our companys longstanding policy regarding the hurdle rates for capital investment decisions. The weighted average cost of capital is simply a blend of the rates of return expected by investors in our company. These investors include banks, bond holders and preferred stock investors in addition to common stockholders, of course, many of you are or soon will be stockholder of our company.

The following table summarizes the composition of ABS financing

The rates of return on the bank loan and bond issue are just the interest rates we pay. However, interest is tax deductible so after-tax interest rates are lower than shown above. For example, the after-tax cost of our bank financing, given our 21% tax rate is 6.3%. The rate of return on preferred stock is 6%. ABS pays 6 pound dividend on each 100 pound preferred shares. 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

ABS business but we must all aspire to superior profitability.

Our calculation of ABS weighted average cost of capital is found to be 11.1%

The official corporate hurdle rate is therefore 11.1% If you have further questions about these calculations, please direct them to our new treasury analyst Sarah.