Case study, Pages 4 (944 words)
1) Why do you believe Larry Stone wishes to estimate the firm’s hurdle rate? Is it understandable to utilize the firm’s weighted average cost of capital as the divisional expense of capital? Please describe.
Larry Stone desires to calculate the company’s hurdle rate because he wishes to have a more reliable basis of information prior to accepting jobs for the company. By figuring out the company’s difficulty rate, their company will also have the ability to make sensible decisions using precise information.
He also thinks that they need to not just count on their “gut feel” since in the future, they won’t be as fortunate as they are since the moment. In our viewpoint, it is justifiable to use the company’s weighted typical cost of capital as the divisional expense of capital. If the jobs of the different divisions have similar risk, this indicates that it’s alright to use the WACC as divisional cost of capital.
If there are different threats, the cost of capital within the very same firm requires to be established.
2) How should Stephanie tackle finding out the cost of financial obligation? Compute the company’s expense of debt. There are really 2 actions associated with computing Oceanic’s expense of debt. The initial step points out the determination of the company’s yield to maturity to be used as the worth representing the Before-Tax Expense of Debt. Subsequently, we can use it in order to calculate for the After-Tax Expense of Financial obligation, which constitutes the next action.
3.) Talk about Stephanie’s presumptions as specified in the event. How sensible are they? At first, many of Stephanie’s assumptions can really be considered practical. Nevertheless, there are still few of them that need to be evaluated as there are particular factors that should be considered before validating the realism of those assumptions. Beginning with those assumptions that tend to be sensible, it is really possible for flotation expenses to be labeled at 5% for financial obligation and 10% for equity as it can be quickly confirmed through talking the investment bankers. Likewise, with the nature of business, where each division is in some way related with each other thus they bear the same levels of danger, it is justifiable for the firm to have the comparable beta in all of its departments.
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.