Professional Documents
Culture Documents
= 05 . 0
50 $
) 05 . 1 ( 19 . 4 $
P
) g 1 ( D
g
P
D
0
0
0
1
+ +
+
= +
= %. 8 . 13 % 0 . 5 % 8 . 8 05 . 0 088 . 0 05 . 0
50 $
40 . 4 $
= + = + = +
F. WHAT IS THE BOND-YIELD-PLUS-RISK-PREMIUM ESTIMATE FOR COLEMANS COST OF
COMMON EQUITY?
ANSWER: [SHOW S10-21 HERE.] THE BOND-YIELD-PLUS-RISK-PREMIUM ESTIMATE IS
14 PERCENT:
k
s
= BOND YIELD + RISK PREMIUM = 10.0% + 4.0% = 14.0%.
NOTE THAT THE RISK PREMIUM REQUIRED IN THIS METHOD IS DIFFICULT TO
ESTIMATE, SO THIS APPROACH ONLY PROVIDES A BALLPARK ESTIMATE OF k
s
. IT
IS USEFUL, THOUGH, AS A CHECK ON THE DCF AND CAPM ESTIMATES, WHICH CAN,
UNDER CERTAIN CIRCUMSTANCES, PRODUCE UNREASONABLE ESTIMATES.
G. WHAT IS YOUR FINAL ESTIMATE FOR k
s
?
ANSWER: [SHOW S10-22 HERE.] THE FOLLOWING TABLE SUMMARIZES THE k
s
ESTIMATES:
METHOD ESTIMATE
CAPM 14.2%
DCF 13.8
k
d
+ RP 14.0
AVERAGE 14.0%
Integrated Case: 10 - 12 Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.
AT THIS POINT, CONSIDERABLE JUDGMENT IS REQUIRED. IF A METHOD IS DEEMED
TO BE INFERIOR DUE TO THE QUALITY OF ITS INPUTS, THEN IT MIGHT BE
GIVEN LITTLE WEIGHT OR EVEN DISREGARDED. IN OUR EXAMPLE, THOUGH, THE
THREE METHODS PRODUCED RELATIVELY CLOSE RESULTS, SO WE DECIDED TO USE
THE AVERAGE, 14 PERCENT, AS OUR ESTIMATE FOR COLEMANS COST OF COMMON
EQUITY.
H. EXPLAIN IN WORDS WHY NEW COMMON STOCK HAS A HIGHER PERCENTAGE COST THAN
RETAINED EARNINGS.
ANSWER: [SHOW S10-23 HERE.] THE COMPANY IS RAISING MONEY IN ORDER TO MAKE AN
INVESTMENT. THE MONEY HAS A COST, AND THIS COST IS BASED PRIMARILY ON
THE INVESTORS REQUIRED RATE OF RETURN, CONSIDERING RISK AND ALTERN-
ATIVE INVESTMENT OPPORTUNITIES. SO, THE NEW INVESTMENT MUST PROVIDE A
RETURN AT LEAST EQUAL TO THE INVESTORS OPPORTUNITY COST.
IF THE COMPANY RAISES CAPITAL BY SELLING STOCK, THE COMPANY DOESNT
GET ALL OF THE MONEY THAT INVESTORS PUT UP. FOR EXAMPLE, IF INVESTORS
PUT UP $100,000, AND IF THEY EXPECT A 15 PERCENT RETURN ON THAT
$100,000, THEN $15,000 OF PROFITS MUST BE GENERATED. BUT IF FLOTATION
COSTS ARE 20 PERCENT ($20,000), THEN THE COMPANY WILL RECEIVE ONLY
$80,000 OF THE $100,000 INVESTORS PUT UP. THAT $80,000 MUST THEN
PRODUCE A $15,000 PROFIT, OR A 15/80 = 18.75% RATE OF RETURN VERSUS A
15 PERCENT RETURN ON EQUITY RAISED AS RETAINED EARNINGS.
I. 1. WHAT ARE TWO APPROACHES THAT CAN BE USED TO ACCOUNT FOR FLOTATION
COSTS?
ANSWER: [SHOW S10-24 HERE.] THE FIRST APPROACH IS TO INCLUDE THE FLOTATION
COSTS AS PART OF THE PROJECT S UP-FRONT COST. THIS REDUCES THE
PROJECT S ESTIMATED RETURN. THE SECOND APPROACH IS TO ADJUST THE COST
OF CAPITAL TO INCLUDE FLOTATION COSTS. THIS IS MOST COMMONLY DONE BY
INCORPORATING FLOTATION COSTS IN THE DCF MODEL.
I. 2. COLEMAN ESTIMATES THAT IF IT ISSUES NEW COMMON STOCK, THE FLOTATION
COST WILL BE 15 PERCENT. COLEMAN INCORPORATES THE FLOTATION COSTS INTO
THE DCF APPROACH. WHAT IS THE ESTIMATED COST OF NEWLY ISSUED COMMON
STOCK, TAKING INTO ACCOUNT THE FLOTATION COST?
Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc. Integrated Case: 10 - 13
ANSWER: [SHOW S10-25 AND S10-26 HERE.]
15.4%. = 5.0% +
$42.50
$4.40
=
5.0% +
0.15) - $50(1
) $4.19(1.05
=
g +
F) - (1 P
g) + (1 D
=
k
0
0
e
J. WHAT IS COLEMANS OVERALL, OR WEIGHTED AVERAGE, COST OF CAPITAL (WACC)?
IGNORE FLOTATION COSTS.
ANSWER: [SHOW S10-27 HERE.] COLEMANS WACC IS 11.1 PERCENT.
CAPITAL STRUCTURE COMPONENT
WEIGHTS COSTS = PRODUCT
0.3 6% 1.8%
0.1 9 0.9
0.6 14 8.4
1.0 WACC = 11.1%
WACC = w
d
k
d
(1 - T) + w
p
k
p
+ w
c
k
s
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.
K. WHAT FACTORS INFLUENCE COLEMAN S COMPOSITE WACC?
ANSWER: [SHOW S10-28 AND S10-29 HERE.] THERE ARE FACTORS THAT THE FIRM CANNOT
CONTROL AND THOSE THAT THEY CAN CONTROL THAT INFLUENCE WACC.
FACTORS THE FIRM CANNOT CONTROL:
LEVEL OF INTEREST RATES
TAX RATES
FACTORS THE FIRM CAN CONTROL:
CAPITAL STRUCTURE POLICY
DIVIDEND POLICY
INVESTMENT POLICY
L. SHOULD THE COMPANY USE THE COMPOSITE WACC AS THE HURDLE RATE FOR EACH
OF ITS PROJECTS?
}
MARKET CONDITIONS
Integrated Case: 10 - 14 Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.
ANSWER: [SHOW S10-30 THROUGH S10-32 HERE.] NO. THE COMPOSITE WACC REFLECTS
THE RISK OF AN AVERAGE PROJECT UNDERTAKEN BY THE FIRM. THEREFORE, THE
WACC ONLY REPRESENTS THE HURDLE RATE FOR A TYPICAL PROJECT WITH
AVERAGE RISK. DIFFERENT PROJECTS HAVE DIFFERENT RISKS. THE PROJECTS
WACC SHOULD BE ADJUSTED TO REFLECT THE PROJECTS RISK.
M. WHAT ARE THREE TYPES OF PROJECT RISK? HOW IS EACH TYPE OF RISK USED?
ANSWER: [SHOW S10-33 AND S10-34 HERE.] THE THREE TYPES OF PROJECT RISK ARE:
STAND-ALONE RISK
CORPORATE RISK
MARKET RISK
MARKET RISK IS THEORETICALLY BEST IN MOST SITUATIONS. HOWEVER,
CREDITORS, CUSTOMERS, SUPPLIERS, AND EMPLOYEES ARE MORE AFFECTED BY
CORPORATE RISK. THEREFORE, CORPORATE RISK IS ALSO RELEVANT. STAND-ALONE
RISK IS THE EASIEST TYPE OF RISK TO MEASURE.
TAKING ON A PROJECT WITH A HIGH DEGREE OF EITHER STAND-ALONE OR
CORPORATE RISK WILL NOT NECESSARILY AFFECT THE FIRMS MARKET RISK.
HOWEVER, IF THE PROJECT HAS HIGHLY UNCERTAIN RETURNS, AND IF THOSE
RETURNS ARE HIGHLY CORRELATED WITH RETURNS ON THE FIRM S OTHER ASSETS
AND WITH MOST OTHER ASSETS IN THE ECONOMY, THE PROJECT WILL HAVE A HIGH
DEGREE OF ALL TYPES OF RISK.
N. WHAT PROCEDURES ARE USED TO DETERMINE THE RISK-ADJUSTED COST OF CAPITAL
FOR A PARTICULAR PROJECT OR DIVISION? WHAT APPROACHES ARE USED TO
MEASURE A PROJECT S BETA?
ANSWER: [SHOW S10-35 THROUGH S10-37 HERE.] THE FOLLOWING PROCEDURES CAN BE
USED TO DETERMINE A PROJECT S RISK-ADJUSTED COST OF CAPITAL:
(1) SUBJECTIVE ADJUSTMENTS TO THE FIRM S COMPOSITE WACC.
(2) ATTEMPT TO ESTIMATE WHAT THE COST OF CAPITAL WOULD BE IF THE
PROJECT/DIVISION WERE A STAND-ALONE FIRM. THIS REQUIRES ESTIMATING
THE PROJECT S BETA.
Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc. Integrated Case: 10 - 15
THE FOLLOWING APPROACHES CAN BE USED TO MEASURE A PROJECT S BETA:
(1) PURE PLAY APPROACH. FIND SEVERAL PUBLICLY TRADED COMPANIES
EXCLUSIVELY IN THE PROJECT S BUSINESS. THEN, USE THE AVERAGE OF
THEIR BETAS AS A PROXY FOR THE PROJECT S BETA. (ITS HARD TO FIND
SUCH COMPANIES.)
(2) ACCOUNTING BETA APPROACH. RUN A REGRESSION BETWEEN THE PROJECTS
ROA AND THE S&P INDEX ROA. ACCOUNTING BETAS ARE CORRELATED
(0.5 - 0.6) WITH MARKET BETAS. HOWEVER, YOU NORMALLY CANT GET
DATA ON NEW PROJECT ROAs BEFORE THE CAPITAL BUDGETING DECISION HAS
BEEN MADE.
O. COLEMAN IS INTERESTED IN ESTABLISHING A NEW DIVISION, WHICH WILL FOCUS
PRIMARILY ON DEVELOPING NEW INTERNET-BASED PROJECTS. IN TRYING TO
DETERMINE THE COST OF CAPITAL FOR THIS NEW DIVISION, YOU DISCOVER THAT
STAND-ALONE FIRMS INVOLVED IN SIMILAR PROJECTS HAVE ON AVERAGE THE
FOLLOWING CHARACTERISTICS:
THEIR CAPITAL STRUCTURE IS 40 PERCENT DEBT AND 60 PERCENT COMMON
EQUITY.
THEIR COST OF DEBT IS TYPICALLY 12 PERCENT.
THE BETA IS 1.7.
GIVEN THIS INFORMATION, WHAT WOULD YOUR ESTIMATE BE FOR THE DIVISIONS
COST OF CAPITAL?
ANSWER: [SHOW S10-38 THROUGH S10-40 HERE.]
k
s DIV.
= k
RF
+ (k
M
- k
RF
)b
DIV.
= 7% + (6%)1.7 = 17.2%.
WACC
DIV.
= W
d
k
d
(1 - T) + W
c
k
s
= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.
Integrated Case: 10 - 16 Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.
THE DIVISIONS WACC = 13.2% VS. THE CORPORATE WACC = 11.1%. THE
DIVISIONS MARKET RISK IS GREATER THAN THE FIRMS AVERAGE PROJECTS.
TYPICAL PROJECTS WITHIN THIS DIVISION WOULD BE ACCEPTED IF THEIR
RETURNS ARE ABOVE 13.2 PERCENT.