Solution to Case 04
Determining the Cost of Capital
Can One Size Fit All?
1. Why do you think Larry Stone wants to estimate the firm’s hurdle rate? Is it justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital? Please explain.
Larry wants to estimate the firm’s hurdle rate because it would provide him with a yardstick with which to measure the feasibility of future investment proposals. The firm had thus far been using a ‘gut feel’ approach and although most of the decisions had turned out to be good ones, Larry was rightfully concerned that the lucky streak could end and put the firm into dire straits.
If the divisional projects were deemed to be of similar risk, using the weighted- average cost of capital (WACC) would be justified. Oceanic’s divisions are basically connected with ship repair and installation service and seem to be involved in projects of similar risk. The WACC would therefore be okay to use.
2. How should Stephanie go about figuring out the cost of debt? Calculate the firm’s cost of debt.
COST OF DEBT
Face Value $1000
10% Coupon( semiannual) $50
YTM (annualized) 11.00%
Tax Rate 34%
After-tax Cost of Debt (annualized) 7.263%
*Ignoring flotation costs
3. Comment on Stephanie’s assumptions as stated in the case. How realistic are they? Here are the assumptions that Stephanie made and comments about their realism: 1. New debt would cost about the same as the yield on outstanding debt and would have the same rating. – Very likely if the ratings haven’t changed. 2. The firm would continue raising capital for future projects by using the same target proportions as determined by the book values of debt and equity – Although in reality firms don’t stick to the exact historical proportions of debt and equity, it can be argued that failure to do so would lead to higher future costs. However, it’s probably better to use current market value weights rather than book value...
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