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Sustainable Growth Rate- Return on Equity x Plowback Ratio Sustainable Growth Rate-4/30 0.5-0.067 Sea Shore Salt's beta had averaged about .5, which made sense, Bernice thought, for a stable, steady-growth business. She made a quick cost of equity calculation by using the capital asset pricing model (CAPM). With current interest rates of about 7%, and a market risk premium of 796, CAPM Cost of Equity TE t B(rm-r) 796 + 0.5(7%)-10.5% This cost of equity was significantly less than the 16% decreed in Mr. Brinepool's memo. Bernice scanned her notes apprehensively. What if Mr. Brinepool's cost of equity was wrong? Was there some other way to estimate the cost of equity as a check on the CAPM calculation? Could there be other errors in his calculations? Bernice resolved to complete her analysis that night. If necessary, she would try to speak with Mr. Brinepool when he arrived at his office the next morning. Her job was not just finding the right number. She also had to figure out how to explain it all to Mr. Brinepool. Assets Working capital Plant and equipment Other assets Liabilities and Net Worth $200 Bank loan $120 80 100 300 360 Long-term debt 0 Preferred stock Common stock, including retained earnings Total $600 Total Notes: L At year-end 2015, Sea Shore Salt had 10 million common shares outstanding 2. The company had also issued 1 million preferred shares with book value of $100 per share. Each share receives an annual dividend of $6 Your Task Your task is to the help Bernice accomplish the following: 1. (20 Points) Is Bernice's boss taking a correct approach to calculate Sea Shore Salt's cost of capital? If not, what should she tell him is the correct approach and what reasons should she present to the boss (she might show all her calculations to him later, see the questions below)? 2. (25 Points) Is Bernice's CAPM calculation correct? If not, what is wrong with it? Ifyes, how can she use a different approach to see if she is, in ballpark, on the right track? 3. (30 Points) Should Bernice suggest modifications for return of other securities (the bank loan, the bond issues, the preferred stocks, 10 Points for each security)? Please comment on each separately. 4. (25 Points) Should Bernice revise the cost of capital calculation? If so, how? What would be her suggested WACC?

Answer 1

Is Bernice's boss taking a correct approach to calculate Sea Shore Salt's cost of capital?

ANSWER: The method used is right , but assumptions regarding cost of equity and preferred shares are not correct due to following reasons:

• The equity cost should be based not required return of the market and not the target cost. Target return may be higher than the cost. This will helping generating economic value added.
• The cost of preferred share and debt should be based on the market yield.
• The proportions of capitals should be based on market value ,not book value

For equity it cost was considered based on target return .For preferred shares cost was considered based on book value.

Is Bernice's CAPM calculation correct?

ANSWER:

CAPM cost of equity =Risk Free Rate+Beta*Market Risk Premium

CAPM cost of equity =7%+(0.5*7%)=10.5%

The calculation is correct .

However, other method to arrive at cost of equity (Required return) would be Dividend Discount Model(DDM)

The dividend growth rate is already established at g=6.7%=0.067

Next years expected dividend =D1

Current Price =$40

Cost of Equity =Required Return=(D1/40)+0.067

D1=$2

Cost of equity =(2/40)+0.067=0.05+0.067=0.117=11.7%

She can consider Cost of Equity at 11% which is approximately at the mid point of the two methods of estimation.

Or it can be considered 11.7%

Should Bernice suggest modifications for return of other securities:

ANSWER:

Yes.

Cost of Equity can be revised to 11.7%

Market value of preferred share=$70

Dividend per year=$6

Cost of preferred shares=6/70=0.086=8.6%

Cost of Bank Loan and Bond do not need revision.

Should Bernice revise the cost of capital calculation?

ANSWER:

Yes.

Detailed calculation given below:

Market value of Common Stock:

Ten million shares outstanding

Market value =$40*10 million =$400 million

Market Value of Preferred shares:

Number of shares=1 million

Market value of preferred shares=$70*1million=$70 million

	A	B=A/670	C	D=B*C
	Amount (Million) (Market value)	Weight	After Tax Cost	Weight *Cost
Bank Loan	$120	0.18	5.20%	0.9%
Bond Issue	$80	0.12	5.04%	0.6%
Preferred stock	$70	0.10	8.60%	0.9%
Common Stock	$400	0.60	11.70%	7.0%
Total	$670	1.00		9.4%

Suggested WACC=9.4%