Determining the Cost of Capital (WACC) Case 19 Can One Size Fit All?

Determining the Cost of Capital (WACC)Case 19Can One Size Fit All?     The Oceanic Corporation, a Chesapeake, VA based company,was established in 1994. Glenn Rodgers III founded the corporation,which was privately owned at the time, after his retirement fromNorentech Corporation.The Oceanic Corporation was originally formed to provide shiprepair services and quickly earned a Department of Defense (DOD)certified Alteration Boat Repair (ABR) designation. Among itsspecialties were structural welding, piping system installation and repairs,electrical, painting, rigging, machinery and dry-dock work, as well ascustom sheet metal fabrication. Other divisions of The Oceanic includedHabitability Installation, Industrial Contracting, andAlteration/ Installation Teams (AIT). With its initial success and goodreturn on investment the firm opened and operated facilities in California,New Jersey, Florida, Maryland, Pennsylvania and Washington.      In 1998, the company went public and its initial public offering was very successful. The stock price had risen from its initial value of $10 to its current level of $35 per share. There were currently 5 million shares outstanding. In 1999, the company issued 30yearbonds at par, with a face value of $1000 and a coupon rate of 10% per year, andmanaged to raise $40 million for expansion. Currently, the AA-ratedbonds had 25 years left until maturity and were being quoted at 91.5 % ofpar.        Over the past year, The Oceanic Corporation utilized a newmethod for fabricating composite materials that the firm’s engineers haddeveloped. In June of last year, management established the AdvancedMaterials Group (AM Group), which was dedicated to pursuing thistechnology. The firm recruited Larry Stone, a senior engineer, to head theAM Group. Larry also had an MBA from a prestigious university underhis belt.          Upon joining Oceanic, Larry realized that most projects werebeing approved on a “gut feel” approach. There were no formalacceptance criteria in place. Up until then, the company had been luckyin that most of its projects had been well selected and it had benefitedfrom good relationships with clients and suppliers. “This has to change,”said Larry to his assistant Stephanie, “we can’t possibly be this luckyforever. We need to calculate the firm’s hurdle rate and use it in future.”Stephanie Phillips, who had great admiration for her boss, replied, “Yes,Larry, why don’t I crunch out the numbers and give them to you withinthe next couple of days?” “That sounds great, Stephanie,” said Larry. “My years of experience tell me that when it comes to the hurdle rate for new projects, one size hardly ever fits all!”       As Stephanie began looking at the financial statements, sherealized that she was going to have to make some assumptions. First, sheassumed that new debt would cost about the same as the yield onoutstanding debt and would have the same rating. Second, she assumedthat the firm would continue raising capital for future projects by usingthe same target proportions as determined by the book values of debt andequity (see Table 1 for recent balance sheet). Third, she assumed that theequity beta (1 .5) would be the same for all the divisions. Fourth, sheassumed that the growth rates of earnings and dividends would continueat their historical rate (see Table 2 for earnings and dividend history).Fifth, she assumed that the corporate tax rate would be 34%, and finally,she assumed that the flotation cost for debt would be 5% of the issueprice and that for equity would be 10% of selling price. The 1yearTreasury bill yield was 4% and the expected rate of return on the marketportfolio was 10%.5. How can Stephanie estimate the firm’s cost of retainedearnings? Should it be adjusted for taxes? Please explain.Determining the Cost of Capital (WACC)Case 19Can One Size Fit All?The Oceanic Corporation, a Chesapeake, VA based company,was established in 1994. Glenn Rodgers III founded the corporation,which was privately owned at the time, after his retirement fromNorentech Corporation.The Oceanic Corporation was originally formed toprovide shiprepair services and quickly earned a Department of Defense (DOD)certified Alteration Boat Repair (ABR) designation. Among itsspecialties were structural welding, piping system installation andrepairs,electrical, painting, rigging, machinery and dry-dock work, as well ascustom sheet metal fabrication. Other divisions of The Oceanic includedHabitability Installation, Industrial Contracting, andAlteration/Installation Teams (AIT). With its initial success and goodreturn oninvestment the firm opened and operated facilities in California,NewJersey, Florida, Maryland, Pennsylvania and Washington.In 1998, the company went public and its initial public offeringwas very successful. The stock price had risen from its initial value of$10 to its current level of $35 per share. There were currently 5million shares outstanding. In 1999, the company issued 30yearbonds at par, with a face value of $1000 and a coupon rate of 10% peryear, andmanaged to raise $40 million for expansion. Currently, the AA-ratedbonds had 25 years left until maturity and were being quoted at 91.5 %ofpar.Over the past year, The Oceanic Corporation utilized a newmethod for fabricating composite materials that the firmâs engineershaddeveloped. In June of last year, management established the AdvancedMaterials Group (AM Group), which was dedicated to pursuing thistechnology. The firm recruited Larry Stone, a senior engineer, to headtheAM Group. Larry also had an MBA from a prestigious university underhis belt.Upon joining Oceanic, Larry realized that most projects werebeing approved on a âgut feelâ approach. There were no formalacceptance criteria in place. Up until then, the company had been luckyin that most of its projects had been well selected and it had benefitedfrom good relationships with clients and suppliers. âThis has tochange,âsaid Larry to his assistant Stephanie, âwe canât possibly be thisluckyforever. We need to calculate the firmâs hurdle rate and use it infuture.âStephanie Phillips, who had great admiration for her boss, replied,âYes,Larry, why donât I crunch out the numbers and give them to you withinthe next couple of days?â âThat sounds great, Stephanie,â saidLarry. âMy years of experience tell me that when it comes to thehurdle rate for new projects, one size hardly ever fits all!âAs Stephanie began looking at the financial statements, sherealized that she was going to have to make some assumptions. First, sheassumed that new debt would cost about the same as the yield onoutstanding debt and would have the same rating. Second, she assumedthat the firm would continue raising capital for future projects byusingthe same target proportions as determined by the book values of debt andequity (see Table 1 for recent balance sheet). Third, she assumed thattheequity beta (1 .5) would be the same for all the divisions. Fourth, sheassumed that the growth rates of earnings and dividends would continueat their historical rate (see Table 2 for earnings and dividendhistory).Fifth, she assumed that the corporate tax rate would be 34%, andfinally,she assumed that the flotation cost for debt would be 5% of the issueprice and that for equity would be 10% of selling price. The 1yearTreasury bill yield was 4% and the expected rate of return on the marketportfolio was 10%.5. How can Stephanie estimate the firmâs cost of retainedearnings? Should it be adjusted for taxes? Please explain.

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