Determining the Cost of Capital
Can One Size Fit All?
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.
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)
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 beta (1.5) would be the same for all the divisions. (This seems quite realistic given the nature of business of the divisions.) 4. The growth rates of earnings and dividends would continue at their historical rate. (Quite Realistic) 5. The corporate tax rate would be 34%. (Seems logical.) 6. The flotation cost for debt would be 5% of the issue price and that for equity would be 10% of selling price. (These can be figured out quite accurately by talking to investment bankers. )
Why there is a cost associated with a firm’s retained earnings?
Retained earnings represent undistributed earnings. Since these earnings belong to shareholders, who could invest them in similar risk investments, it is fair that if a firm chooses not to distribute them as dividends, it should earn a rate of return on these earnings that is appropriate with what shareholders can earn in the market. Hence, retained earnings have an opportunity cost for shareholders.
How can Stephanie estimate the firm’s cost of retained earnings? Should it be adjusted for taxes? Please explain.
Stephanie can use the CAPM Model, Bond-yield-plus-risk-premium approach, or The DCF Model to estimate the firm’s cost of retained earnings.
rs = rRF + (rm –rRF)bi
= 4% + (10%-4%)(1.5)
Bond Yield-Plus-Risk-Premium Approach:
rs = YTM + RP
= 10.80% + 4%
The DCF Model:
rs = (D1/P0) + g
= [0.25(1+ 0.165* )] /$35 + 0.165
= 0.1733 or 17.33%
* 0.10(1 + g)6 = 0.25
(1 + g)6(1/6) = 6 2.5
1 + g = 1.1650
g = 0.1650 or 16.50%
The cost of equity does not have to be adjusted for taxes because the return earned by
common stockholders is based on the firm’s net income, which is...
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