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 Stone wants to calculate the firm’s hurdle rate because he wants to have a more reliable basis of information before accepting projects for the company. By determining the firm’s hurdle rate, their company will also be able to make prudent decisions using accurate data. He also thinks that they should not just rely on their “gut feel” because in the future, they won’t be as lucky as they are as of the moment. In our opinion, it is justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital. If the projects of the different divisions have similar risk, this means that it’s okay to use the WACC as divisional cost of capital. If there are different risks, the cost of capital within the same firm needs to be established.

2) How should Stephanie go about figuring out the cost of debt? Calculate the firm’s cost of debt. There are actually two steps involved in calculating Oceanic’s cost of debt. The first step cites the determination of the firm’s yield to maturity to be used as the value representing the Before-Tax Cost of Debt. Subsequently, we can apply it in order to compute for the After-Tax Cost of Debt, which constitutes the next step.

3.) Comment on Stephanie’s assumptions as stated in the case. How realistic are they? Initially, most of Stephanie’s assumptions can genuinely be considered realistic. However, there are still few of them that need to be reviewed as there are certain factors that ought to be considered before confirming the realism of those assumptions. Starting with those assumptions that tend to be realistic, it is actually possible for flotation costs to be labeled at 5% for debt and 10% for equity as it can be easily confirmed through talking the investment bankers. Also, with the nature of the business, wherein each division is somehow interrelated with each other hence they bear the same levels of risk, it is justifiable for the firm to have the similar beta in all of its divisions.

Lastly, it can also be considered realistic for growth rates of earnings and dividends to continue at their historical rate, for the corporate tax rate to be measured at 34%. On the other hand, the assumption that ‘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’ can be somehow unreasonable as stock prices are generally subject to price changes that therefore would probably affect the proportion of the equity. In addition, we also find it unrealistic that acquiring new debts would cost about the same as the yield on outstanding debt and would have the same rating as interest rates is a factor which the firm cannot control. Though, it can occur likely under the condition that the ratings would maintain stable.

4.) Why there is a cost associated with a firm’s retained earnings? The cost which is associated in retained earnings represents the opportunity cost which the stockholders face. Since retained earnings are earnings held by the company which is to be reinvested in the business, such earnings must earn at least as much as what the alternative investments might have earned if invested by the stockholders. Instead of returning the interest of the stockholders over the earnings, the firm now is faced with the challenge of gaining as many benefits to maximize the earnings reinvested.

5.) How can Stephanie estimate the firm’s cost of retained earnings? Should it be adjusted for taxes? Please explain. There are actually two methods feasible in order to compute for the cost of retained earnings. One of which is done by dividing the expected dividend by the current price of the company’s share and then add the growth rate.

The cost of retained earnings shall not be adjusted for taxes because retained earnings are already net of tax. Earnings before tax is being deducted by tax to get the net income, then the net income when deducted by the dividends to be released, we have the retained earnings. So the cost of retained earnings should not be adjusted for taxes.

6.) Calculate the firm’s average cost of retained earnings. Calculating for the firm’s average cost of retained earnings can be simply done by getting the average between the two results acquired by the use of both DCF and CAPM model.

7.) Can flotation costs be ignored in the analysis? Explain. In this case, having a flotation cost for debt as much as 5% and for equity as much as 10% already comprises a material amount, and if ignored, there would be a tendency of miscalculation that would eventually lead to the misinterpretation of the information. Though it is not an essential variable in computing for the WACC, flotation costs are actually accounted in measuring the value of the project which is the main contributing factor for the firm to make decisions on whether to pursue that project or not.

8.) How should Stephanie calculate the firm’s hurdle rate? Calculate it and explain the various steps. Before we compute for the firm’s hurdle rate, we first need to compute for the weights in relation to the firm’s debt and equity. When we speak of weights, it actually refers to the proportion of the component from the total. Thus we need to find first the market values for each component.

Courtney from Study Moose

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