Determining the Cost of Capital: Can One Size Fit All?
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 standard with which to measure feasibility of future investment proposal. 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 strictly concerned that the his luck could end and put the firm into dire situations.
If the divisional projects were deemed to be of similar risk, using the weighted- average cost of capital (WACC) would be justified. 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. Estimated YTM = [Interest + (FV-MV)/n ]÷ (FV+MV)/2 = [100+(1000-915)/25] ÷ (1000+915)/2 = 0.1080 0r 10.80% After-tax rd = 10.80% (1-0.34) = 7.13%
3. Comment on Stephanie’s assumptions as stated in the case. How realistic are they?
Assumptions 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 proportions since prices of these securities and hence their weights have changed significantly.) 3. The equity
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 standard with which to measure feasibility of future investment proposal. 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 strictly concerned that the his luck could end and put the firm into dire situations.
If the divisional projects were deemed to be of similar risk, using the weighted- average cost of capital (WACC) would be justified. 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. Estimated YTM = [Interest + (FV-MV)/n ]÷ (FV+MV)/2 = [100+(1000-915)/25] ÷ (1000+915)/2 = 0.1080 0r 10.80% After-tax rd = 10.80% (1-0.34) = 7.13%
3. Comment on Stephanie’s assumptions as stated in the case. How realistic are they?
Assumptions 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 proportions since prices of these securities and hence their weights have changed significantly.) 3. The equity