Spring Vacation Beach, Florida
DATE: May 15, 2012
TO:Joe-Bob Brinepool, President
FROM:Bernice Mountaindog, Treasury Analyst
SUBJECT:Cost of Capital
This has reference to your memo dated January 15, 2006 clarifying the company’s long-standing policy regarding hurdle rates for capital investment decisions.
In determining the cost of equity, the undersigned employed two different models, first using the Capital Asset Pricing Model (CAPM) which yielded the following calculation:
CAPM cost of equity: re = rf + β (rm – rf)
Sea Shore Salt’s beta had averaged about 0.5 considering the stable, steady growth of business and with the current interest rates of about 7%, and a market risk premium of 7%, the cost of equity is 10.5%
Second approach is using the dividend discount model, as follows:
re = (D1 / Po) + g*
With the common stock traded at $40 per share, next year’s earning per share would be about $4 and dividends per share probably at $2. In addition, traditionally, the company paid out 50% of the earnings as dividends plowed back the rest. The sustainable growth rate was determined to be 6.7%. Considering the foregoing values, the return on equity using the dividend discount model is computed at 11.7%.
In determining the bank’s loan rate, I relied on the information that the bank charges the company at current market rates which means that the bank loan rate changes when market rates change.
The preferred stock is also not selling at par, as against Mr. Brinepool assumption that the rate of return for the preferred stock is stand at 6%. With the preferred stock selling at $70, the rate of return should be,
rpreferred = D / Po = $6/$70 = 0.086 or 8.6%
In calculating the WACC, I reflected the market values (not book value) in consistency with your priority in investor rate of return expectations, as follows:
| Amount$| Percent of Total%| Rate of Return%|