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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 assessment the firm's hurdle rate because it would extend 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 luck could end and put the firm into dire situations. If the divisional project were deemed to be of similar risk, using the weighted average cost of capital, would be justified, therefore the WAAC should be fine to use. 2. How should Stephanie go about figuring out the cost of debt? Calculate the firm’s cost of debt? Par = $1000 Coupon rate =10% Current Price (quoted @ 9.15% of Par) = $915 (0.915×1000) N = 25 Tax-rate = 34% F−P n F +P 2

C+ Therefore, YTM = Where, C=coupon rate F= Face Value P= Price

N= No of years to maturity 1000−915 } 25 1000+915 { } 2

100+ { =

YTM= 10.7988% (before-tax cost of debt)

After- tax cost of debt = Before-tax cost of debt × (1-T) = 10.79 88 × (1-0.34) = 7.13%

3. Comment on Stephen’s assumption as state in the case, how realistic are they? 4. Why is there a cost associated with retained earnings? Management may either pay out earnings in the form of dividends or else retain earnings for reinvestment in the business. If part of the earnings is retained, an opportunity cost is incurred: stockholders could have received those earnings as dividends and then invested that money in stocks, bonds, real estate, and so on. 5. How can Stephanie estimate the firm’s cost of retained earnings? Should it be adjusted for taxes? Please explain. Cost of retained earning can be calculated the same way as cost of equity. It is the return stockholders require on the company's common stock. There are two approaches to determine the cost of equity. 1) SML Approach Using, E ( R E )=

M −¿ Rf f +¿ β( R¿ R¿

= 4 + 1.5 ( 10−4 ¿ = 13% 2) Dividend Growth Model RE = Where,

D1 +g P0 D1 = next periods dividend P0 = Price per share of stock g= growth rate

Finding g, Year 1998 1999

Dividend 0.10 0.12

Dollar Change 0.02

2000

0.15

0.03

2001

0.18

0.03

2002

0.20

0.02

2003

0.22

0.02

2004

0.25

0.03

% Change 0.12−0.10 = 0.2 0.10 0.15−0.12 = 0.25 0.12 0.18−0.15 0.15 0.20−0.18 0.18 0.22−0.20 0.20 0.25−0.22 0.22

= 0.2 = 0.111 = 0.1 = 0.136

Average growth rate = (0.2+0.25+0.2+0.11+0.1+0.14)/6 = 16.61%

RE =

0.25(1+0.1661) 35

+ 0.1661

= 17.32%

The cost of equity need not to be adjusted for taxes, this is because the return earned by common stockholders is based on net income, which is an after-tax item.

6. Calculate the firm’s average cost of retained earnings. Average cost of retained earnings =

(13+17.32) = 15.16% 2

7. Can floatation cost be ignored in the analysis? Explain. In this case floatation can’t be ignored because the firm issues new bond to finance new project. This means the firm incurs some cost for financing new project, this cost is called floatation cost.

8. How should Stephanie calculate the firms hurdle rate? Calculate it and explain the various steps Stephanie can calculate the firm’s hurdle rate using the WACC, since it is assumed the risk of all projects is similar to the firms existing operation.

WACC= (

E ) × RE + V

D V

× R D × (1-T)

Using Book Value Capital Structure Weights Step 1: Determine the Book Value of Equity Book value = $50,000,000 Step 2: Determine the Market Value of Debt Book value = $40,000,000 Step 3: Determine Total Book Value of Capital. Book Value of Capital = Book value of equity + Book value of debt.

=

$ 50,000,000

+ 40,000,0000

= $90,000,000 Step 4: Determine the Capital Structure Weights Equity Weight = Debt Weight =

$ 50,000,000 $ 90,0 00,000

= 0.6

$ 4 0 , 000,000 $ 90,000 ,000

= 0.4

Step 5: Calculate WACC Where, Cost of debt = 7.13% as calculated in question 2 Cost of equity = 15.16% as calculated in question 6 WACC= (0.6) × 15.16 + (0.4) × 7.13 × (1-0.34) = 10.98%

Using Market value Capital Structure Weights. Step 1: Determine the Market Value of Equity Number of share outstanding = 5,000,000 Market price per share = $35 Total market value of equity = $175,000,000 (5,000,000 × 35) Step 2: Determine the Market Value of Debt Shares Outstanding = 40,000 Market Price = $915 Total market value of debt = $36,600,000 (40,000 × 915) Step 3: Determine Total Market Value of Capital. Market Value of Capital = Market value of equity + Market value of debt. =

$ 175,000,000

= $211,600,000 Step 4: Determine the Capital Structure Weights

+ $36,600,000

Equity Weight = Debt Weight =

$ 175,000,000 $ 211,600,000 $ 36,600,000 $ 211,600,000

= 0.827 = 0.173

Step 5: Calculate WACC Where, Cost of debt = 7.13% as calculated in question 2 Cost of equity = 15.16% as calculated in question 6 WACC= (0.827) × 15.16 + (0.173) × 7.13 × (1-0.34) = 13.35% Therefore the firms hurdle rate is 13.35%

9. Can Larry assume that the hurdle rate calculated by Stephanie would remain constant? Please explain. No, Larry can’t assume that the hurdle rate calculated will remain constant because as the debt level increases, it is very likely that the firm’s rating could change and investors would demand higher rates to buy its securities. Furthermore, the cost of equity could change as well if the firm’s beta changes.