Can One Size Fit All?

CASE DESCRIPTION?
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,
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.
 Here are the assumptions that Stephanie made and comments about their realism:

 
 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.
 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 –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.
 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.
 The growth rates of earnings and dividends would continue at their historical rate
– quite realistic.
 The corporate tax rate would be 34% - seems logical.
 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 is there a cost associated with a firm’s retained
earnings?
 Why is there 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
stands to reason that if a firm chooses not to
distribute them as dividends, it should earn a rate of
return on these earnings that is commensurate 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.
 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 TAKEN

AS THE COST OF EQUITY
WHICH MIGHT BE ADJUSTED FOR PERSONAL
TAXES OR BROKERAGE
Calculate the firm’s average cost of retained earnings
Table 2 The Oceanic Corporation Sales,
Earnings, and Dividend History ('000s) Year
Sales Earnings per Share Dividends per
Share
Average Growth Rate 16.62%
How can Stephanie estimate the firm’s cost of retained
earnings? Should it be adjusted for taxes? Please explain.

Stephanie can use the Dividend Growth Model and/or the Security Market
Line (SML) approach to estimate the firm’s cost of retained earnings.

Dividend Growth Model Approach

 RE = D1/Po + gm = Dividend Yield + Growth Rate
D0 = $0.25 (see Table 2 in the case)
gm = Constant growth rate = 16.2%
Po = $35
 RE = (0.25*(1+0.162) /$35)+0.162
 = 17.5%
SML Approach
 RE = Rf + BE X [E(RM-Rf)]
 = 4.4% + 1.5(10% - 4%)
 = 13.4%
Average Cost of Retained Earnings = (17.21% +
13.4%)/2 = 15.31%
Can flotation costs be ignored in
the analysis? Explain.
when analyzing the Net Present Value of projects, the weighted flotation cost must be
accounted for before a decision is made. For example,
 
Let’s say there’s a project, which has an initial cost of $1,000,000 and no retained
earnings available.
 
Weighted average flotation cost = Weight of debt*Flotation cost of debt + Wt.
Of equity * Flotation cost of new equity
 
Component Price # outstanding Market Value Wt.____ Wt.____
Debt $915 40,000 36,600,00017.297%
Equity $35 5,000,000 175,000,000 82.71%
Total MV of Capital 211,600.000 100%
 
 
Total Flotation Cost= 17.29% * 5% + 82.71% * 10% = 9.135%
How should Stephanie calculate the firm’s
hurdle rate? Calculate it and explain the
various steps.
 =(0.175*0.82)+(0.0726*0.172)
=15.6%

Thus the hurdle rate that can be used to discount the

cash flows of future projects is either of these two or
average.
Can Larry assume that the hurdle rate
calculated by Stephanie would remain
constant? Please explain.
Can Larry assume that the hurdle rate calculated by Stephanie would remain constant?
Please explain.

 
No, Larry cannot assume that the hurdle rate
calculated by Stephanie would remain constant
because as the debt level increases, it is very likely
that the firm’s ratings 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.
