Case 35. Q4

Q.No. 4: Using Hudson Bancorp¶s estimates of the costs of debt and equity in case Exhibit 8,which rating category has the lowest overall cost of funds? Do you agree with HudsonBancorp¶s view that equity investors are indifferent to the increases in financial risk acrossthe investment-grade debt categories?There is a general concept that higher rating category willhavethe lowest cost of debt. Butrating categories only give the information about the default risk and loss in case of companydefault. It does not guarantee the lowest cost of capital. For the lowest cost of capital we mustneed to analyse the WACC and we should select the category providing less WACC but thecategory must be at-least BBB.WACC is the minimum rate of return that a company must earn in order to stay in the break-even position. Return below the WACC will lead the company toward deficit, so everyorganization wants higher return thanitsWACC. Companies generate its funds from varioussources like: securities, debt, convertibles etc. and all these sources have certain weight.Therefore, WACC considers all the sources and the cost associated with them along with theweights of the sources.WACC alone cannot give the optimal value for the shareholders; it only provides theminimum cost range. WACC and market value of the company move simultaneously andthese two are the major determinant of rating category. Generally, as the market valueincreases, WACC startsto decline. In the process there will be one optimal level where thedifference between WACC and market value will be maximum(Refer to the graph below);similarly level of debt-to-equity will be maximizing the shareholders¶ value??Yo line pad taek chotiThereforeI opine that thecompany should not focus more on credit rating, rather it shouldconcentrate on maximizing the shareholders value. By maintaining minimum WACC,company can get its range for optimal credit rating. This can be shown by figure below:

Figure: Minimum Level of WACC where