Focus on comparable rates of return investors can expect to receive and compare to Bernice’s target book value return on equity. Use the CAPM calculations and consider WACC as well. The tables are attached, and the Case is: Bernice Mountaindog was glad to be back at Sea Shore Salt. Employees were treated well. When she had asked a year ago for a leave of absence to complete her degree in finance, top management promptly agreed. When she returned with an honors degree, she was promoted from administrative assistant (she had been secretary to Joe-Bob Brinepool, the president) to treasury analyst. Bernice thought the company’s prospects were good. Sure, table salt was a mature business, but Sea Shore Salt had grown steadily at the expense of its less-well-known competitors. The company’s brand name was an important advantage, despite the difficulty most customers had in pronouncing it rapidly. Bernice started work on January 2nd, 2018. The first 2 weeks went smoothly. Then Mr. Brinepool’s cost of capital memo (see figure 13.2) assigned her to explain Sea Shore Salt’s weighted-average cost of capital to other managers. The memo came as a surprise to Bernice, so she stayed late to prepare for the questions that would surely come the next day. Bernice first examined Sea Shore Salt’s most recent balance sheet, summarized in Table 13.6. Then she jotted down the following additional points: The company’s bank charged interest at current market rates, and the long-term debt had just been issued. Book and market values could not differ by much. But the preferred stock had been issued 35 years ago, when interest rates were much lower. The preferred stock, originally issued at a book value of $100 per share, was now trading for only $70 per share. The common stock traded for $40 per share. Next year’s earnings per share would be about $4 and dividends per share probably $2. (Ten million shares of common stock are outstanding.) Sea Shore Salt had traditionally paid out 50% of earnings as dividends and plowed back the rest. Earnings and dividends had grown steadily at 6% and 7% per year, in line with the company’s sustainable growth rate: Sustainable growth rate = return on equity x plowback ratio = 4/30 x .5 = .067, or 6.7% Table 13.6 See Sea Shore Salt’s balance sheet, taken from the company’s 2017 balance sheet (figures in $millions) Sea Shore Salt’s beta had averaged about .5, which made sense, Bernice thought, for a stable, steady-growth business. She made a quick cost of equity calculation by using the capital asset pricing model (CAPM). With current interest rates of about 7%, and a market risk premium of 7%. CAPM cost of equity = 7% + .5(7%) = 10.5% This cost of equity was significantly less than the 16% decrease in Mr. Brinepool’s memo. Bernice scanned her notes apprehensively. What if Mr. Brinepool’s cost of equity was wrong? Was there some other way to estimate the cost of equity as a check on the CAPM calculation? Could there be other errors on his calculations? Bernice resolved t complete her analysis that night. If necessary, she would try to speak with Mr. Brinepool when he arrived at his office the next morning. Her job was not just finding the right number. She also had to figure out how to explain it all to Mr. Brinepool.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Hi! I am having difficulty with an analysis that I have to do on the attached minicase. The hint that we were provided to go off of is as follows:
Focus on comparable rates of return investors can expect to receive and compare to Bernice’s target book value
The tables are attached, and the Case is:
Bernice Mountaindog was glad to be back at Sea Shore Salt. Employees were treated well. When she had asked a year ago for a leave of absence to complete her degree in finance, top management promptly agreed. When she returned with an honors degree, she was promoted from administrative assistant (she had been secretary to Joe-Bob Brinepool, the president) to treasury analyst.
Bernice thought the company’s prospects were good. Sure, table salt was a mature business, but Sea Shore Salt had grown steadily at the expense of its less-well-known competitors. The company’s brand name was an important advantage, despite the difficulty most customers had in pronouncing it rapidly.
Bernice started work on January 2nd, 2018. The first 2 weeks went smoothly. Then Mr. Brinepool’s cost of capital memo (see figure 13.2) assigned her to explain Sea Shore Salt’s weighted-average cost of capital to other managers. The memo came as a surprise to Bernice, so she stayed late to prepare for the questions that would surely come the next day.
Bernice first examined Sea Shore Salt’s most recent
- The company’s bank charged interest at current market rates, and the long-term debt had just been issued. Book and market values could not differ by much.
- But the
preferred stock had been issued 35 years ago, when interest rates were much lower. The preferred stock, originally issued at a book value of $100 per share, was now trading for only $70 per share. - The common stock traded for $40 per share. Next year’s earnings per share would be about $4 and dividends per share probably $2. (Ten million shares of common stock are outstanding.) Sea Shore Salt had traditionally paid out 50% of earnings as dividends and plowed back the rest.
- Earnings and dividends had grown steadily at 6% and 7% per year, in line with the company’s sustainable growth rate:
Sustainable growth
= 4/30 x .5
= .067, or 6.7%
Table 13.6 See Sea Shore Salt’s balance sheet, taken from the company’s 2017 balance sheet (figures in $millions)
Sea Shore Salt’s beta had averaged about .5, which made sense, Bernice thought, for a stable, steady-growth business. She made a quick
CAPM cost of equity = 7% + .5(7%) = 10.5%
This cost of equity was significantly less than the 16% decrease in Mr. Brinepool’s memo. Bernice scanned her notes apprehensively. What if Mr. Brinepool’s cost of equity was wrong? Was there some other way to estimate the cost of equity as a check on the CAPM calculation? Could there be other errors on his calculations?
Bernice resolved t complete her analysis that night. If necessary, she would try to speak with Mr. Brinepool when he arrived at his office the next morning. Her job was not just finding the right number. She also had to figure out how to explain it all to Mr. Brinepool.
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