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1. Why do you think Larry Stone wants to estimate the firms hurdle rate?

Is it
justifiable to use the firms 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
firms cost of debt?
Par = $1000
Coupon rate =10%
Current Price (quoted @ 9.15% of Par) = $915 (0.9151000)
N = 25
Tax-rate = 34%
FP
n
F +P
2

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

N= No of years to maturity
1000915
}
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 Stephens 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 firms 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 +
(
R
R

= 4 + 1.5 ( 104
= 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
0.120.10
= 0.2
0.10
0.150.12
= 0.25
0.12
0.180.15
0.15
0.200.18
0.18
0.220.20
0.20
0.250.22
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 firms 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 cant 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 firms 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 cant assume that the hurdle rate calculated will remain constant because as
the debt level increases, it is very likely that the firms rating could change and
investors would demand higher rates to buy its securities. Furthermore, the cost of
equity could change as well if the firms beta changes.