Case 34 Determining the Corporate Cost of Capital COBA Corporation (Part A) WW. F. Kenner, president and general manager of COBA Corporation paced back and forth as hae considered ihe business awaiting him in the afternoon meeting. The meeting was to include Jule Tiffin, COBA's treasurer, Jan Bergerson, COBA's controller, and Kenner, The discussion ‘was to center around the calculation of the appropriate cost of capital for the corporation, ‘The company, whose name was formed fiom the names of the smaller enterprises that \were combined to form the present company, manufactured a variety of items forthe health care industry. The firm's operations were divided into two segments: Division A, which ‘manufactured hospital clothing such as surgical gowns, masks, and other outer covering for surgical staff; and Division B, which manufactured sterilized items such as scalpels and hypodermic needles. ‘The present company was formed in 1978. Its stock was firs offered to the public the {following year. The company joined several more well-established firms in an industry that had ‘experienced steady growth since the 1950s. The industry was characterized by efficient production practices, prompt delivery ofits products, and limited flexibility in terms of pricing the various products. COBA’s manufacturing operations were modern and efficient by industry standards. ‘The two operating divisions were located in the same city and the corporate office was inthe suburban northem end of the city. The company’s sales and earnings had increased at a significant rate over the past few years; Table | illustrates that trend. Given the sales and earnings growth experienced by COBA, finding viable internal investments (cepital budgeting projects) was not a problem for the company. It was the issue of capital budgeting, however, which had given rise to the upcoming meeting. During the ‘company’s bret history its proposed capital budget was developed in the following manner: (1) Tiffin and Bergerson developed a funding plan for the company. ‘That i, they determined the ‘amount of funds available for investment in property, plant, and equipment and the source of those funds forthe coming fiscal year. (2) The divisions developed a capital needs plan based upon the marketing research and replacement expenditure information put together by the division controller. (3) The division budgets were modified to conform to the funding plan developed by Tiffin and Bergerson, (4) The final capital budget represented those expenditures for each division selected based upon their net present value (NPV) or their internal rate of rotum (IRR), Iwas the task of the company's treasurer and controller to assess the primary influences upon the companys stock price, risk and, retum (COBA operated without a vice president of finance; those duties, planning and policy-setting, were shared by Tiffin and Bergerson.) 34-1Case 34 ‘COBA Corporation (Part A) havetto be addressed. A question that was often debeted during the budgeting season was the relationship of the discount rate used in the capital budgeting analysis to the firm's cost of capital, Why was Tiffin's motto "Marginal cost equals marginal revenue?” What did that have todo with anything? ‘An issue that the two financial managers wanted to settle before the meeting was ‘whether en ongoing relationship with an investment banker was necessary. While there were no specific plans being made to raise additional cepts, the firm’ strategic plans made such an ‘event ikely within the next two years, As a result information about such things as debt rating, debt costs, and risk characteristics in the industry as seen by external analysts was needed. “Therefore, it was against this background that the top-level management of COBA sought to establish a consensus among the members ofthe divisional financial staff on the cost of capital, TABLE 1 COBA Corporation Sales and Earnings History Earnings per Dividends per Year Sales Share ‘Share 1987 ‘$15,000,000 $0.90 $037 i988. 16,800,000, 1.01 0.40 1989 18,750,000 13 04s 1990 21,600,000 130 0.53 1991 24,600,000 148, 0.60 1992 26,850,000 161 0.65 1993 32,500,000 L95 079 1994 33,100,000 2.00 ost 1995 37,140,000 223 ot TABLE 2 COBA Corporation Balance Sheet December 31, 1995 (5000s) ‘Total current assets $800 | Total curent liabilities $250 Land $8,000] Long-term debt (at 9%) $21,750 Buildings (net) Common stock Equipment (net) 2.200 | (2m shares outstanding) 20,000 ‘Total fixed assets $46,200 | Retained earnings 5,000 Total assets $47,000 | Total liabilities and net worth 47,000 _ | 34-3COBA Corporation (Part A) {CHALLENGE QUESTION] 3. What is the probable meaning of Tiffin's motto? ‘Tifin's motto, MR = MC, means that if the appropriate cost of capital is used in the capital budgeting analysis then the analyst can be assured of approving those projects that increase the value of the firm, to the point where NPV = $0, 4. What is the projected dividend growth rate? “The projected rate is approximately 12 percent, which is based upon the Gordon model's assumption that past growth will continue into the future. [CHALLENGE QUESTION} 5, Calculate the weighted average book cost of capital for COBA. Discuss each of the ‘component costs. ‘Assume that current liabilities are a constant percentage of the firm's financing and are, therefore, a part ofthe firm's permanent financing. ky = theafer-tax cost of debt, oF 0.09 x (I - tax rate), = 0.09 x (1-035) = (0.09x0.65) = 0.0585 = 5.85 percent. where: d, = dx (+a) = $0.91 x (1#0.12) = $1.02; and P, = $20.00 Tmus k= (81.02 +$20.00) + 0.12 = 17.1% ‘The weighted average cost of capital is: (5.85% xw) + (17.1% XW) = (0.0585 x 0.468) + (0.1710 x 0.532) = 118% 343Case 34 COBA Corporation (Part A) 6. What is the relationship, if any, of the current abil capital? ies to the company's cost of “The relationship of current liabilities to the cost of eapital depends upon whether the Tiablities are temporary or permanent. Ifthey area relatively permanent peroentage of total capital then they are added to the total debt in assigning the "weight" of debt tothe ‘otal capital structure 7. Comment on the optimal capital structure as it relates to the cost of capital. ‘Am optimal capital structue must be known or assumed in order to calculate, and rely fpon, the weighted average cost of capital. Ifnot, then each time the ~weighs” of the capitl components change (the percent of debt, equity or preferred, to total expta, the cost of capital will change. 8 What are some advantages of establishing a relationship with an investment banker? “The investment banker will provide current information concerning the cepital markets. ‘Such information as bond rating information, investor perceptions, and the location of private placements fra firms securities may be provided by an investment banker [CHALLENGE QUESTION] 9. Whats the meaning of the opportunity cost of eapital for the divisions relative to the firm's overall cost of capital? “The opportunity cost of capitals specific to each set of cash flows, Thats, the variation in the expected cash flows influences the discount rate for those flows—this equates 10 urging revenue. Therefore fone division's cash lows ae ata different level of isk, find the opportunity cos of funds will be influenced by that risk, that isthe opportuni frthat division, The cost of capital fr the multi-dvisional firm, as a whole, is another matter, (See Cole-Williams, Case 36.) 10, What is the role of the opportunity cost in capital budgeting? “The discount rate per division, or other operating unit, isthe opportunity cost of capita for that division. Division cash lows are discounted atthe opportunity cost of capital for that division, 34-4Case 34 COBA Corporation (Part A) 11. Discuss the cost of retained earnings versus the cost of new equity. If these costs differ, why do they differ? The cost of retained earnings is relevant until a break point is reached — that is, until expenditures for capital investment, given an optimal capital structure, dictate the ‘issuance of "new equity," which has a higher cost (due to brokerage fees or flotation costs) than retained earings. 12, What, if anything, would cause a fundamental (permanent) change in the firm's cost of capital? Such a change may be caused by changes inthe firm's line of business and markets (a ‘Strategic change) or a change in the optimal capital structure. y 34.5Case 35 Risk Management and Corporate Capital Costs COBA Corporation (Part B) ‘Afr the meetin, Tiffin and Bergerson were feeling some relief and some apprehension over the way things went. ‘They were relieved because they believed that Kenner now fully understood why they made financial decisions in such @ manner. In addition, the more ‘experienced finmeial stat fiom each ofthe divisions were also "tuned i,” Their apprehension arose, however, from a series of questions raised by Kara Sims, a finance major and summer intem from a nearby unversiy. Sims questions seemed to imply that COBA's approgch to cost ‘of capital calculations was less than up-to-date ‘The young summer inter was especially interested in Tiffin and Bergerson's views conceming the book versus market cot of eaptal. For example, how did these differ, and did the difference, if any, influence the manner in which capital budgeting was conducted, othe ‘esuls that were obttned? Tn other words, Ms Sims wanted to make clear the following point: (1) the dividend model ad some inherent shortcomings; and (2) capital investment decisions, the primary use forthe cost of capital, should be made with regard to marginal cost as well as marginal revenue ‘These issues and concems were not new to Tiffin and Bergerson. They were sure that each of Sims’ points was relevant, and they decided that all matters concerning the cost of eepital hha tobe cleared up imumeitely. Only then could it be decided whether another meeting wi Kenner and te dvisona finance and accounting staff was warranted. In order to resolve things inthe mos efficient manner possible, a special project was designed for Sims, Tnessence, Tiffin and Bergerson wanted Sims to design a cost of capital manual for use by COBA management. The issues tobe deat with inthe manual were those alluded to by Sims carer. These could be enumerated as follows: 1. Explain the diference between book value cost of capital and market value cost of capital 2. Discuss an alternative to the dividend model of use in calculating the cost of equity. Specifically outline, in clear detail, the Capital Asset Pricing Model (CAPM) approach to the cost of equity. 3. Conceming item 2, describe the sources fr the parameters ofthe CAPM or its relevant component, the Security Market Line (SML) 4, What effec, ifany, will any changes to the cost of capital calculation have upon ‘the firm's capital budgeting activities and the number and type of projets it ukimately accepts? 38-1Case 35 COBA Corporation (Part B) divisions. Bach division's cost of capital would in a CAPM seting, be based upon the Partctla characteristics of the individual division. The idea and practice of comparing an pera vision to afr that operates solely in tha line of business was known asthe “pune. play" technique. ‘Therefore, the debt level ofa division's pure-play, and the cost of debe ther resulted fom tat det level, helped to determine the division's cost of capital. In general, the greater the debt level ofa division, the greater the division's beta coefficient. (Beta measures the nondiversifiabl risk ofa security, such as a company’s stock, or an operating division of ‘company. Sims began work onthe assignment immediately. She believed that a thorough job would be good for the progressive and well-run company and would also assure her s mare Pennarient poston there. As a result of these motivation, Sims wanted tobe as systematic as Possible in her task As a first sep she wanted to recast the company's balance sheet, shown in Table 1, in the most current manner possible. It was clear to Sims that the long-term capital items in the capital structure would ‘ppear differently ifthe value of each was calculated using market weights. She knew, for instance, that debt identical tothe 9 percent debt now outstanding for COBA could be iscued with a7 percent yield, The market value of the common stock was $20 at present. As a result of tat information, a market value capital structure would have to be calculated as a part fhe task, (Recall thet the firm's income tax rate is 35 percent.) ‘mode, which Sims finance professor insisted was superior to intemally influenced medele sack {5s dividend model, was the analytical approach she wanted to emulate. Specifically, the ndividual company aspect ofthe CAPM known as the security market line would be uscd vg caleulate the firm's equity cost, the required yield on equity. Sins knew fo example, tht the parameters forthe SMI. included a risk-fee (or, very {ow tisk) interest rate, the return on a market average of common stock, andthe rns bets, ‘bes twas clear that a low rik proxy used in the SML was the retum on U.S. Treasury bill jee eands ctstanding have an assumed maturity value of $1,000 and e remaining matty of 15 years. In addition, the imbalance on the balance sheet reslting from the market vals of capital would be corrected by assigning replacement value to the land, buildings, and equipment [Te finns beta could be calculated or simply found in one of several publications that carried financial ratios and similar information. The retum on the market index eould be ‘aleulated or assumed to be represented by the ROE of a broad market index (such « munber Ws approximately 12.5 percent atthe end of 1992). Sims, equipped with the foregoing dete 4and information, belived she was ready to prepare an up-to-date cost of capital fe the company. ‘he retum on the marke calculation may be handle in atleast two ways; (J) by jubreting ftom the historical average retum on common stock the historical average returs en tieh-eade corporate bonds and adding the diference tothe curently prevailing rte on highs {aie exporate bonds or (2) a specific ool of stocks (all industria stocks oral ily stocks) 35.2Case 35 ‘COBA Corporation (Part B) ‘might be assessed for their level of return over some time period. In any case, the objective is to obtain as representative «figure as possible relative to the factors that influence stock returns TABLE 1 COBA Corporation Balance Sheet December 31, 1995 6000s) Total current assets $800 | Total current liabilities $250 Land $8,000 | Long-term debt (at 9%) $21,750 Buildings (net) 26,000 | Common stock Equipment (net) | (2m shares outstanding) Total fixed assets $46,200 | Retained earnings Total assets $47,900 _|_Total liabilities and net worth QUESTIONS What isthe purpose of using market values in cost of capital calculations? What is COBA's cost of equity using the dividend model (see COBA A)? Using the ‘SML? Explain the difference between these numbers. (Assume thatthe risk-free rate of interest is 5 percent, and the firm's beta is 1.41.) What is COBA's weighted average market value cost of capital using the information in Question 27 Whatis the beta for each of COBA\s divisions if, in a pure-play sense, division A has a ‘market value debt of $11.5 million, and division B has a market value debt of $14.7 nillion and the firm's total market value equity is invested equally in each division? (The unlevered beta is 1.0.) ‘Answer item 4 from the case, Ifthe company had only three capital expenditure projects up for consideration prior to ‘Sims’ work and the respective IRRs on the three were 16.3 percent, 11.7 percent, and 11.4 percent; how would Sims' calculations affect the disposition of these projects? 35-3Case 35 10. 1 ‘COBA Corporation (Part B) ‘What capital structure assumption is implicit in the task assigned to Sims? What is the rationale for preference of the externally influenced SMA. in the cost of capital calculation? In general, how have interest rates on long-term debt behaved over the past five Years? That is, what are the high and low levels of such rates over the period? Consider your answer to Question 8. What is the implication for the cost of capital calculation? Is the weighted average cost of capital the only correct discount rate to use in capital investment decisions? ‘Comment upon the rationale for historical data and trends being reflected in the return ‘on the market calculation used in the SMI equation. 35-4