The Oceanic Corporation
(Determining the Cost of Capital)
Larry Stone wants to estimate the firm’s hurdle rate because it is a benchmark for how well the company needs to do on a project in order to at least break even. The higher the hurdle rate, the riskier the project will have to be and the lower the hurdle rate is, the safer the project will be for a company. A company should strive for a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate or better, then the cash should be given as dividends to the stockholders. As long as the risk is roughly the same for all divisions and there are no outliers, then it doesn’t matter if Larry uses the weighted average cost of capital or divisional cost of capital. The weighted average cost of capital is an average that reflects each division’s importance to the average by multiplying by a factor. The cost of debt can be calculated by using the yield to maturity (YTM) as an approximation. Per my calculations, the firm’s cost of debt is 10.84%. Stephanie’s assumptions are very safe. Her first assumption that new debt would cost about the same as the yield on outstanding debt and would have the same rating is not realistic. It has been five years since the debt being used to calculate the YTM has been issued. The market fluctuates and while it could be that the percent and rating stay the same, it can’t be guaranteed. For our purposes of calculating for the company we will assume she is correct in all of her statements. Second, her assumption should read that the firm will continue raising capital for future projects by using target proportions as determined by the fair market values of debt and equity. Book value is a historical value that doesn’t reflect market changes.
Third, the equity beta would not be the same for all divisions because the beta is a measure of volatility. Each division is going to have its...
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