The management of Taylor Brands has a philosophy of "better to be safe than sorry" when

selecting a discount rate. At present the firm uses a 30 percent rate, which many company

executives feel is unreasonably high and results in the following difficulties. First, some projects

considered to be worthwhile and important are rejected because their expected return is close to,

but still below, the 30 percent minimum. Second, managers have a tendency to be overly optimistic in their cash flow projections in order to get their pet projects accepted. Third, there is the feeling

that the rate is at best arbitrarily determined and at worst something that Trevor Unruh-Taylor's

general manager- has "pulled out of a hat".

ROBERT WEST

Robert West is one of Taylor's more innovative and thoughtful executives. A few years ago he correctly perceived that a successful firm in the food wholesaler'sindustry-Taylor's main industry-

would have to expand into nonfood items. After extensive study, West recommended that Taylor add such products as light hardware and paper plates to the variety of goods it sells to grocery stores. This strategy worked remarkably well. Taylor's customers benefited because they dealt with fewer vendors and invoices. Taylor gained customers (many were referrals) and also reduced its unit cost by making more efficient use of its trucking capacity. West has developed an interest in the financial side of business. During the past year he attended two seminars on cost of capital estimation, using his personal leave time and at his own expense. He has been eager to apply this newly acquired knowledge, and after a number of discussions Unruh told West to "determine Taylor's cost of capital and make a formal report on your findings".

It seemed to West that this was a major coup since Unruh paid little attention to the financial side of the business. He was told privately, however, that Unruh is "really unimpressed and bored with

the entire idea; he assigned you this project because he knew you were eager to do it, and Unruh admires your initiative". West was told quite bluntly that "nothing will come of your efforts".

Initially deflated, West became determined to do a thorough evaluation, and he felt sure that he could convince Unruh of the importance of obtaining and accurate cost of capital. "At the very least," West thought, "a formal investigation of our cost of capital will eliminate the perception that is arbitrarily determined."

In preparation for making the estimate West reviewed is notes from one of the seminars he had attended. (See Exhibit 1) He recalled the instructor emphasizing that estimating the required return on equity was especially delicate; and although the instructor gave two models for measuring this return, he emphasized there was "no substitute for good judgment."

FINANCIAL INFORMATION

West also collected some financial information that he felt was relevant to analysis. He knows the company has recently obtained a bank note at 7 percent and that the company's bonds were originally issued at 7 percent but are currently selling at a discount with a yield to maturity of about

8 percent.

Taylor's EPS has grown quite impressively in the last five years (see Exhibit 3), but West knows Unruh encouraged a relatively constant dividend per share over this period since he preferred to reinvest much of the company's earnings. West doesn't believe this will continue since Unruh is under pressure from major stockholders to bring dividend growth in line with earnings growth. Nor is it likely that past EPS growth can be maintained. First, during this period the industry itself had unusual prosperity. Second, some of this past growth was a result of the firm's movement into nonfood items, and these opportunities are virtually exhausted. Third many corporate insiders felt

Taylor had been a bit lucky.

West decides it is reasonable to suppose that Taylor will implement a 70 percent payout ratio; after all, it makes no sense to retain a large proportion of earnings when investment opportunities are not as plentiful as in the past. He also fells that the company will achieve an average return of 12 percent on any retain earnings. Though these figures on payment and return are some-thing of "guesstimates, West was able to find support for these numbers among Taylor's managers.

Most financial analysts consider the Industry to be of average risk, and in fact, beta estimates for Taylor range from 8 to 12.West decides, however, that these estimates are a bit high, because the firm is in the process of altering production techniques that will reduce the company's degree of operating leverage. And there is another difficulty. At present Taylor has no preferred stock in its capital structure.

But West knows that there are plans to issue some in the next few months, though the price and dividend per share have not yet been determined. However, he does have some information on the preferred stock of three of Taylor's competitors. (See Exhibit 6.) These companies are much larger than Taylor and are considered less risky because they have a more diversified product line and customer base and enjoy a lower degree of operating leverage (even after the change in Taylor's production techniques). He is also aware that the yield difference on the preferred stock of firms in roughly the same industry is 75 to 100 basis points.

"I've got quite a bit of info, West thought. I hope I can put it all together to make a report that will impress Unruh."

QUESTIONS

1. West intends to adjust Taylor's beta estimates slightly downward in view of the fact that

the firm's degree of operating leverage is decreasing. Does such an adjustment seem

appropriate? Explain

2. The required return on equity (cost of equity), Ke, can be estimated in a number of ways.

(a) Estimate Ke using a risk premium approach.

(b) Use the dividend valuation model to estimate Ke.

(c) In your view, what is Ke? Justify your choice.

3. Estimate Taylor's cost of capital or required rate of return. (You may use book values in

your calculations. Assume the existing capital structure is optimal and ignore preferred

stock. The relevant tax rate is 40 %.)

4. Preferred stock is a riskier investment than a bond. Yet companies have been known to

issue preferred stock at a lower yield than they issue bonds. How can this be, assuming

investors are rational?

5. (a) Estimate the cost of preferred stock (required return of preferred stock).

(b) Redo question 3 including preferred stock as a financing source, and assume the target

weights are as follows: notes, 5 %; bonds, 40%; preferred, 5%; equity, 50%.

6. What additional information would you like in order to make more informed estimates

about the cost of equity and the cost of preferred stock?

7.Would you recommend that West use market or book values in is presentation? Defend

your recommendation.

8. Apparently the 30% hurdle rate used by Taylor exceeds its actual cost of capital or required

rate of return. Let us suppose a company errs in others direction and choses a hurdle rate

considerably less than its actual cost of capital. What difficulties could this cause?

9. West believes that Taylor's high cost of capital encourages managers to develop overly

optimistic cash flow forecasts. Is a more accurate cost of capital estimate likely to reduce

this bias, as he apparently thinks? Explain your answer.

EXHIBIT 1

Excerpts from West's Notes on the Cost of Capital Seminars

1. The instructor said the cost of capital is really the required rate of return or hurdle rate that should be used to evaluate capital budgeting projects of average risk for the company. (Indeed, he much prefers the term "required rate of return" to the more common but potentially misleading "cost of capital.")

2. The cost of capital is a weighted average of the required return on each financing source. Theoretical accuracy requires these weights be obtained at the market values of debt, equity, and (if applicable) preferred stock. The instructor said, however, that most firms use book values because (1) it is easier, and (2) market values tend to vary widely.

3. The instructor recommended that all debt that does not require an explicit return be excluded when calculating the weights described in part 2. (Usually this means excluding accounts payable and accruals.)

4. The required return on each financing source should be based on current market conditions.

5. The instructor recommended that flotation costs be ignored. While theoretically incorrect this omission simplifies the calculations and does not significantly alter the estimate.