I need help find the Weighted Average Cost of Capital as well as the Weighted Average Flotation Costs
COST OF CAPITAL EXERCISE
The Stone Meat Corporation is a mediumâsized agricultural products company headquartered in Ogden, Utah. Its primary products are beef, pork and poultry and include packaged deli meats to half animals sold directly to in-store butcher markets in the retail grocery stores. They also supply their own butcher packs to various retail outlets including grocery stores, big box stores, and restaurants. In addition, they have their own factory store. The firm's products are well recognized within the markets in terms of quality and food safety.
During the 2000's and the early 2010's sales and earnings had grown rapidly. Sales in 2002 were approximately $60 million, but had reached $180 million by 2012. Per share earnings and dividends more than kept pace. The relevant figures are contained in Exhibit 1.
In order to support the firm's expansion, substantial expenditures on plant and equipment were required during the period indicated. The majority of funds came from retained earnings and the private placement of debentures with insurance companies. In 2004, however, the company was forced to sell additional common stock because it felt that the debt level, which would ensue from trying to borrow the money to keep up its expansion program, would be excessive. In particular, possible adverse effects in its stock price were feared since, at the time, the firm's ratio of debt to total capitalization was already somewhat above the industry average of 30 percent. The firm's balance sheet as of December 31, 2012 is shown in Exhibit 1.
Originally, the company's Board of Directors had established a policy of paying out half its annual earnings as dividends. The actual percentage varied from year to year because an attempt was made to stabilize the dividends despite fluctuating profit. By the late 2000's, this policy had been revised to set oneâthird of earnings as the target payâout ratio due to the continuing need for capital. At their last annual meeting, the Directors announced that the 2012 dividend would be 60 cents per share, payable quarterly in 15 cent installments. The company's stock is listed on the AMEX and trades actively. The range of yearly stock prices is included in Exhibit 1. The closing price on June 30, 2012 was $24.
Market data indicated that Stone was somewhat less risky than the market as a whole with a beta of .80. Returns on the market were averaging approximately 12% and risk free borrowing was still low following the financial meltdown of 2008. These rates averaged 3.5%. Preferred stock, which had been issued many years ago as a part of a financial deal, was selling at $90 per share. Tax rates had averaged 30% over the last few years.
Early in 2012, the treasurer of Stone was reviewing its investment and financing strategies with an eye toward improving both. The question as to an appropriate cutâoff ratio of return on new investments was of special concern. The treasurer was of the opinion that many capital expenditures had been made in the past without proper analysis. He wanted a figure he could justify to the firm's managers as a cost of capital in order to achieve a more accurate capital budgeting procedure throughout the organization. He felt this was an especially timely move in view of an article he had just read in the WSJ and which is reproduced in Exhibit Ill. Stone's own longârange planning group had earlier forecast a trend not unlike that indicated in the Journal.
The treasurer was well aware that financing did not come free and that the costs of issuance of preferred stock would cost 8%, bonds would cost 4% and equity 12%. He thought it important to determine how such costs would inflate the costs of any proposed projects the company might pursue in the futures. Thus he wanted to determine what the total cost of a $1,000,000 investment would be after considering any financing costs.
Year Sales in MillionsOf Dollars EPS DPS Stock Price Range 2002 60 0.560 0.30 6-10 2003 63 0.500 0.30 5-9 2004 68 0.710 0.35 5-10 2005 85 0.880 0.40 8-12 2006 97 0.820 0.45 9-14 2007 119 0.940 0.45 12-20 2008 130 1.110 0.45 11-18 2009 145 1.350 0.45 15-24 2010 164 1.300 0.50 17-27 2011 173 1.600 0.50 20-30 2012 180 1.750 0.60 24-32
Exhibit II Balance Sheet As of 12/31/2012 (figures in millions) Cash 20 Accounts Receivable 10 Inventories 30 Plant and Equipment, net 60 Total Assets 120 Accounts Payable 20 Misc Accruals 10 Preferred Stock (5%) 10 Long term Debt 24 Common Stock (2.5 million shares) 12 Capital Surplus 4 Retained Earnings 40 Total Liabilities and Equity 120 The firm's bonds carried a 6% coupon, (paid semi- annually) a 12/31/2022 maturity and were selling for $960 as of 6/30/2012.
EXHIBIT III
Article taken form the February 7, 2012 issue of the Wall Street Journal.
Meat Processing Industry To Be Hurt by Increasing Prices?
Decimated Life stock Herds Also Contribute to Price Increases.
Kansas (AP) â The ConAgra Corporation, in a recent annual meeting announcement, forecast a trailing off of sales in its meat processing division. That division, which had been growing at a rate equivalent to three times the CPI growth rate throughout the 2000's and early 2010's, may be hit by decreases in household expenditures as the effects of the most recent financial crisis are still lingering for the decimated middle class. Retail outlets such as restaurants and grocery stores are reporting that sales of beef and pork products are declining in response to price pressures. Disease that swept through beef and pork herds, are also having a telling effect. Other sources close to the industry confirm the ConAgra prognosis. They estimate the best forecasts that their economists can come up with indicate a decline of about five percent in the growth rate which had been experienced in the last 12 to 15 years. ConAgra is curtailing several plant expansions in its meat processing division which were on the drawing board for the midâ2010's." We are moderately pessimistic," a company spokesman indicated, "and are going to adopt a wait and see attitude for the next year or so."
Hints
Create the Cost of Capital
Number of shares can be determined by taking the book value and dividing by the par value of the securities.
Market value is shares X price.
Average the two possible ways to calculate the cost of equity
Remember the tax rate.
Assume the bonds are semi - annual
The term to maturity is from 6/30/2012 to 12/31/2022 or 10.5 years. This info is in the footnote to Exhibit II
The growth rate should be determined from the EPS data and the adjustment to the growth rate is in Exhibit III
Create the Weighted Average Flotation Cost
What is the cost of equity using the dividend growth model? (Decimal answer to the fourth decimal place)
Given the $1,000,000 cost of the investment, what is the total cost of the investment including flotation costs? (Round to whole numbers)
I need help find the Weighted Average Cost of Capital as well as the Weighted Average Flotation Costs
COST OF CAPITAL EXERCISE
The Stone Meat Corporation is a mediumâsized agricultural products company headquartered in Ogden, Utah. Its primary products are beef, pork and poultry and include packaged deli meats to half animals sold directly to in-store butcher markets in the retail grocery stores. They also supply their own butcher packs to various retail outlets including grocery stores, big box stores, and restaurants. In addition, they have their own factory store. The firm's products are well recognized within the markets in terms of quality and food safety.
During the 2000's and the early 2010's sales and earnings had grown rapidly. Sales in 2002 were approximately $60 million, but had reached $180 million by 2012. Per share earnings and dividends more than kept pace. The relevant figures are contained in Exhibit 1.
In order to support the firm's expansion, substantial expenditures on plant and equipment were required during the period indicated. The majority of funds came from retained earnings and the private placement of debentures with insurance companies. In 2004, however, the company was forced to sell additional common stock because it felt that the debt level, which would ensue from trying to borrow the money to keep up its expansion program, would be excessive. In particular, possible adverse effects in its stock price were feared since, at the time, the firm's ratio of debt to total capitalization was already somewhat above the industry average of 30 percent. The firm's balance sheet as of December 31, 2012 is shown in Exhibit 1.
Originally, the company's Board of Directors had established a policy of paying out half its annual earnings as dividends. The actual percentage varied from year to year because an attempt was made to stabilize the dividends despite fluctuating profit. By the late 2000's, this policy had been revised to set oneâthird of earnings as the target payâout ratio due to the continuing need for capital. At their last annual meeting, the Directors announced that the 2012 dividend would be 60 cents per share, payable quarterly in 15 cent installments. The company's stock is listed on the AMEX and trades actively. The range of yearly stock prices is included in Exhibit 1. The closing price on June 30, 2012 was $24.
Market data indicated that Stone was somewhat less risky than the market as a whole with a beta of .80. Returns on the market were averaging approximately 12% and risk free borrowing was still low following the financial meltdown of 2008. These rates averaged 3.5%. Preferred stock, which had been issued many years ago as a part of a financial deal, was selling at $90 per share. Tax rates had averaged 30% over the last few years.
Early in 2012, the treasurer of Stone was reviewing its investment and financing strategies with an eye toward improving both. The question as to an appropriate cutâoff ratio of return on new investments was of special concern. The treasurer was of the opinion that many capital expenditures had been made in the past without proper analysis. He wanted a figure he could justify to the firm's managers as a cost of capital in order to achieve a more accurate capital budgeting procedure throughout the organization. He felt this was an especially timely move in view of an article he had just read in the WSJ and which is reproduced in Exhibit Ill. Stone's own longârange planning group had earlier forecast a trend not unlike that indicated in the Journal.
The treasurer was well aware that financing did not come free and that the costs of issuance of preferred stock would cost 8%, bonds would cost 4% and equity 12%. He thought it important to determine how such costs would inflate the costs of any proposed projects the company might pursue in the futures. Thus he wanted to determine what the total cost of a $1,000,000 investment would be after considering any financing costs.
| Year | Sales in MillionsOf Dollars | EPS | DPS | Stock Price Range |
| 2002 | 60 | 0.560 | 0.30 | 6-10 |
| 2003 | 63 | 0.500 | 0.30 | 5-9 |
| 2004 | 68 | 0.710 | 0.35 | 5-10 |
| 2005 | 85 | 0.880 | 0.40 | 8-12 |
| 2006 | 97 | 0.820 | 0.45 | 9-14 |
| 2007 | 119 | 0.940 | 0.45 | 12-20 |
| 2008 | 130 | 1.110 | 0.45 | 11-18 |
| 2009 | 145 | 1.350 | 0.45 | 15-24 |
| 2010 | 164 | 1.300 | 0.50 | 17-27 |
| 2011 | 173 | 1.600 | 0.50 | 20-30 |
| 2012 | 180 | 1.750 | 0.60 | 24-32 |
| Exhibit II | |
| Balance Sheet As of 12/31/2012 (figures in millions) | |
| Cash | 20 |
| Accounts Receivable | 10 |
| Inventories | 30 |
| Plant and Equipment, net | 60 |
| Total Assets | 120 |
| Accounts Payable | 20 |
| Misc Accruals | 10 |
| Preferred Stock (5%) | 10 |
| Long term Debt | 24 |
| Common Stock (2.5 million shares) | 12 |
| Capital Surplus | 4 |
| Retained Earnings | 40 |
| Total Liabilities and Equity | 120 |
| The firm's bonds carried a 6% coupon, (paid semi- | |
| annually) a 12/31/2022 maturity and were selling for | |
| $960 as of 6/30/2012. | |
EXHIBIT III
Article taken form the February 7, 2012 issue of the Wall Street Journal.
Meat Processing Industry To Be Hurt by Increasing Prices?
Decimated Life stock Herds Also Contribute to Price Increases.
Kansas (AP) â The ConAgra Corporation, in a recent annual meeting announcement, forecast a trailing off of sales in its meat processing division. That division, which had been growing at a rate equivalent to three times the CPI growth rate throughout the 2000's and early 2010's, may be hit by decreases in household expenditures as the effects of the most recent financial crisis are still lingering for the decimated middle class. Retail outlets such as restaurants and grocery stores are reporting that sales of beef and pork products are declining in response to price pressures. Disease that swept through beef and pork herds, are also having a telling effect. Other sources close to the industry confirm the ConAgra prognosis. They estimate the best forecasts that their economists can come up with indicate a decline of about five percent in the growth rate which had been experienced in the last 12 to 15 years. ConAgra is curtailing several plant expansions in its meat processing division which were on the drawing board for the midâ2010's." We are moderately pessimistic," a company spokesman indicated, "and are going to adopt a wait and see attitude for the next year or so."
Hints
Create the Cost of Capital
Number of shares can be determined by taking the book value and dividing by the par value of the securities.
Market value is shares X price.
Average the two possible ways to calculate the cost of equity
Remember the tax rate.
Assume the bonds are semi - annual
The term to maturity is from 6/30/2012 to 12/31/2022 or 10.5 years. This info is in the footnote to Exhibit II
The growth rate should be determined from the EPS data and the adjustment to the growth rate is in Exhibit III
Create the Weighted Average Flotation Cost
What is the cost of equity using the dividend growth model? (Decimal answer to the fourth decimal place)
Given the $1,000,000 cost of the investment, what is the total cost of the investment including flotation costs? (Round to whole numbers)
Related questions
The Stone Meat Corporation is a mediumâsized agricultural products company headquartered in Ogden, Utah. Its primary products are beef, pork and poultry and include packaged deli meats to half animals sold directly to in-store butcher markets in the retail grocery stores. They also supply their own butcher packs to various retail outlets including grocery stores, big box stores, and restaurants. In addition, they have their own factory store. The firm's products are well recognized within the markets in terms of quality and food safety. During the 2000's and the early 2010's sales and earnings had grown rapidly. Sales in 2002 were approximately $60 million, but had reached $180 million by 2012. Per share earnings and dividends more than kept pace. The relevant figures are contained in Exhibit 1. In order to support the firm's expansion, substantial expenditures on plant and equipment were required during the period indicated. The majority of funds came from retained earnings and the private placement of debentures with insurance companies. In 2004, however, the company was forced to sell additional common stock because it felt that the debt level, which would ensue from trying to borrow the money to keep up its expansion program, would be excessive. In particular, possible adverse effects in its stock price were feared since, at the time, the firm's ratio of debt to total capitalization was already somewhat above the industry average of 30 percent. The firm's balance sheet as of December 31, 2012 is shown in Exhibit 1. Originally, the company's Board of Directors had established a policy of paying out half its annual earnings as dividends. The actual percentage varied from year to year because an attempt was made to stabilize the dividends despite fluctuating profit. By the late 2000's, this policy had been revised to set oneâthird of earnings as the target payâout ratio due to the continuing need for capital. At their last annual meeting, the Directors announced that the 2012 dividend would be 60 cents per share, payable quarterly in 15 cent installments. The company's stock is listed on the AMEX and trades actively. The range of yearly stock prices is included in Exhibit 1. The closing price on June 30, 2012 was $24. Market data indicated that Stone was somewhat less risky than the market as a whole with a beta of .80. Returns on the market were averaging approximately 12% and risk free borrowing was still low following the financial meltdown of 2008. These rates averaged 3.5%. Preferred stock, which had been issued many years ago as a part of a financial deal, was selling at $90 per share. Tax rates had averaged 30% over the last few years. Early in 2012, the treasurer of Stone was reviewing its investment and financing strategies with an eye toward improving both. The question as to an appropriate cutâoff ratio of return on new investments was of special concern. The treasurer was of the opinion that many capital expenditures had been made in the past without proper analysis. He wanted a figure he could justify to the firm's managers as a cost of capital in order to achieve a more accurate capital budgeting procedure throughout the organization. He felt this was an especially timely move in view of an article he had just read in the WSJ and which is reproduced in Exhibit Ill. Stone's own longârange planning group had earlier forecast a trend not unlike that indicated in the Journal. The treasurer was well aware that financing did not come free and that the costs of issuance of preferred stock would cost 8%, bonds would cost 4% and equity 12%. He thought it important to determine how such costs would inflate the costs of any proposed projects the company might pursue in the futures. Thus he wanted to determine what the total cost of a $1,000,000 investment would be after considering any financing costs
Exhibit 1
Year Sales eps dps Stock Price
|
|
|
|
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||
Exhibit II
Balance Sheet As of 12/31/2012 (figures in Millions)
Cash 20 Accounts Receivable 10 Inventories 30 Plant and Equipment, net 60 Total Assets 120 Accounts Payable 20 Misc Accruals 10 Preferred Stock (5%) 10 Long term Debt 24 Common Stock (2.5 million shares) 12 Capital Surplus 4 Retained Earnings 40 Total Liabilities and Equity 120 The firm's bonds carried a 6% coupon, a 12/31/2022 maturity and were selling for $960 as of 6/30/2012.
What is the cost of preferred stock?
Taylor Brands
Cost of Capital or Required Rate of Return
The management of Taylor Brands has a philosophy of "better to be safe than sorry" when selecting a discount rate. At present the firm uses a 30 percent rate, which many company executives feel is unreasonably high and results in the following difficulties. First, some projects considered to be worthwhile and important are rejected because their expected return is close to, but still below, the 30 percent minimum. Second, managers have a tendency to be overly optimistic in their cash flow projections in order to get their pet projects accepted. Third, there is the feeling that the rate is at best arbitrarily determined and at worst something that Trevor Unruh-Taylor's general manager-has "pulled out of a hat."
ROBERT WEST
Robert West is one of Taylor's more innovative and thoughtful executives. A few years ago he correctly perceived that a successful firm in the food wholesalers industry-Taylor's main industry-would have to expand into nonfood items. After extensive study, West recommended that Taylor add such products as light hardware and paper plates to the variety of goods it sells to grocery stores. This strategy worked remarkably well. Taylor's customers benefited because they dealt with fewer vendors and invoices. Taylor gained customers (many were referrals) and also reduced its unit cost by making more efficient use of its trucking capacity.
West has developed an interest in the financial side of the business. During the past year he attended two seminars on cost-of-capital estimation, using his personal leave time and at his own expense. He has been eager to apply this newly acquired knowledge, and after a number of discussions Unruh told West to "determine Taylor's cost of capital and make a formal report on your findings." It seemed to West that this was a major coup since Unruh paid little attention to the financial side of the business. He was told privately, however, that Unruh is "really unimpressed and bored with the entire idea; he assigned you this project because he knew that you were eager to do it, and Unruh admires your initiative." West was told quite bluntly that "nothing will come of your efforts."
Initially deflated, West became determined to do a thorough evaluation, and he felt sure that he could convince Unruh of the importance of obtaining an accurate cost of capital. "At the very least," West thought, "a formal investigation of our cost of capital will eliminate the perception that it is arbitrarily determined."
In preparation for making the estimate West reviewed his notes from one of the seminars he had attended. (See Exhibit 1.) He recalled the instructor emphasizing that estimating the required return on equity was especially delicate; and although the instructor gave two models for measuring this return, he emphasized there was "no substitute for good judgment."
FINANCIAL INFORMATION
West also collected some financial information that he felt was relevant to the analysis. He knows the company has recently obtained a bank note at 7 percent and that the company's bonds were originally issued at 7 percent but are currently selling at a discount with a yield to maturity of about 8 percent.
Taylor's EPS has grown quite impressively in the last five years (see Exhibit 3), but West knows Unruh encouraged a relatively constant dividend per share over this period since he preferred to reinvest much of the company's earnings. West doesn't believe this will continue since Unruh is under pressure from major stockholders to bring dividend growth in line with earnings growth. Nor is it likely that past EPS growth can be maintained. First, during this period the industry itself had unusual prosperity. Second, some of this past growth was a result of the firm's movement into nonfood items, and these opportunities are virtually exhausted. Third, many corporate insiders felt Taylor had been a bit lucky.
West decides it is reasonable to suppose that Taylor will implement a 70 percent payout ratio; after all, it makes no sense to retain a large proportion of earnings when investment opportunities are not as plentiful as in the past. He also feels that the company will achieve an average return of 12 percent on any retained earnings. Though these figures on payout and return are something of "guesstimates," West was able to find support for these numbers among Taylor's managers.
Most financial analysts consider the industry to be of average risk, and in fact, beta estimates for Taylor range from .8 to 1.2. West decides, however, that these estimates are a bit high, because the firm is in the process of altering production techniques that will reduce the company's degree of operating leverage.
And there is another difficulty. At present Taylor has no preferred stock in its capital structure. But West knows that there are plans to issue some in the next few months, though the price and dividend per share have not yet been determined. However, he does have some information on the preferred stock of three of Taylor's competitors. (See Exhibit 6.) These companies are much larger than Taylor and are considered less risky because they have a more diversified product line and customer base and enjoy a lower degree of operating leverage (even after the change in Taylor's production techniques). He is also aware that the yield difference on the preferred stock of firms in roughly the same industry is 75 to 100 basis points.
"I've got quite a bit of info," West thought. "I hope I can put it all together to make a report that will impress Unruh."
EXHIBIT 1
Excerpts from West's Notes on the Cost of Capital Seminars
1. The instructor said the cost of capital is really the required rate of return or hurdle rate that should be used to evaluate capital budgeting projects of average risk for the company. (Indeed, he much prefers the term "required rate of return" to the more common but potentially misleading "cost of capital.")
2. The cost of capital is a weighted average of the required return on each financing source. Theoretical accuracy requires these weights be obtained at the market values of debt, equity, and (if applicable) preferred stock. The instructor said, however, that most firms use book values because (1) it is easier, and (2) market values tend to vary widely.
3. The instructor recommended that all debt that does not require an explicit return be excluded when calculating the weights described in part 2. (Usually this means excluding accounts payable and accruals.)
4. The required return on each financing source should be based on current market conditions.
5. The instructor recommended that flotation costs be ignored. While theoretically incorrect this omission simplifies the calculations and does not significantly alter the estimate.
EXHIBIT 2
| Historical Estimates of Yearly Returns on Various Investments: 1926-1992 | |
| Investment | (Arithmetic Average) Average Yearly Return (%) |
| Common stocks | 12.1 |
| Small capitalization stocks | 17.1 |
| Long-term government bonds | 4.9 |
| Long-term corporate bonds | 5.5 |
EXHIBIT 3
| EPS and DPS Information on Taylor | ||||
| Year | EPS | Change (%) | DPS | Change (%) |
| 1991 | $0.73 | $0.40 | ||
| 1992 | 0.82 | 12.3 | 0.40 | 0 |
| 1993 | 1.14 | 39.0 | 0.40 | 0 |
| 1994 | 1.85 | 62.3 | 0.41 | 2.5 |
| 1995 | 2.35 | 27.0 | 0.43 | 4.9 |
| 1996 (present) | 2.83 | 20.4 | 0.45 | 4.7 |
EXHIBIT 4
| Financial Information Compiled by West | |
| Treasury bill rate | 5.5% |
| Long-term government bond rate | 7% |
| Long-term corporate bond rate | 8% |
| Current annual yield on Taylor's long-term debt | 8% |
| Current dividend on Taylor's stock | $0.45 |
| Price range of Taylor's stock, previous year | 28-36 |
| Rate on recent short-term loan (note) | 7% |
| Taylor's tax rate | 40% |
EXHIBIT 5
| Taylor's Financial Structure at Book Values ($000s) | |
| Accounts payable | 45,000 |
| Notes payable | 16,000 |
| Accruals and other current liabilities | 8,000 |
| Bonds | 89,000 |
| Common stock | 58,000 |
| Retained earnings | 72,000 |
| Total liabilities and equity | 288,000 |
EXHIBIT 6
| Preferred Stock Information on Taylor's Competitors | |||
| Firm | Original Price of Preferred | Current Price of Preferred | Dividend |
| Super Foods | $50 | $40 | $3.00 |
| Easton | $41 | $31 | $2.25 |
| Westgate | $46 | $45 | $3.00 |
Please Answer 1, 2a, 2b, 4, 6, 7d, 9a, 9b, 10a, 10b
Question 1
West intends to adjust Taylor's beta estimates slightly downward in view of the fact that the firm's degree of operating leverage is decreasing. Does such an adjustment seem appropriate? Explain.
Question 2
The required return on equity (cost of equity), Ke, can be estimated in a number of ways.
(a) Estimate Ke using a risk premium approach.
(c) In your view, what is Ke? Justify your choice.
Question 4
Preferred stock is a riskier investment than a bond. Yet companies have been known to issue preferred stock at a lower yield than they issue bonds. How can this be, assuming investors are rational?
Question 6
What additional information would you like in order to make more informed estimates about the cost of equity and the cost of preferred stock?
Question 7
(d) Estimate Taylor's cost of capital or required return assuming that these market values are consistent with the financing weights desired by management. (You may ignore preferred stock.)
Question 9
(a) Apparently the 30 percent hurdle rate used by Taylor exceeds its actual cost of capital or required rate of return. Let us suppose a company errs in the other direction and chooses a hurdle rate considerably less than its actual cost of capital. What difficulties could this cause?
(b) West believes that Taylorâs high cost of capital encourages managers to develop overly optimistic cash flow forecasts. Is a more accurate cost-of-capital estimate likely to reduce this bias, as he apparently thinks? Explain your answer.
Question 10
(a) Suppose that West will present a summary of his findings to senior management. Would you recommend that he presents his estimate or Taylorâs required return (cost of capital) as XX percent, XX.X percent or XX.XX percent? That is, how- if at all- would you suggest the estimate be rounded off? (Keep in mind that he is likely to be questioned thoroughly by Unruh, who appears skeptical of Westâs efforts.)
(b) Would you recommend that West use market or book values in his presentation? Defend your recommendation.
