Question

Simply Cayenne Company: A Comprehensive Case In Measuring A Firm's Cost Of Capital (Boudreaux, D., S. Rao, and P. Das, 2014) THE CASE Patricia Hotard, the Chief Executive Officer of Simply Cayenne Refining and Processing Company (SCRPC), picked up the telephone to call Jimmy Breez, the firm's financial manager. Breez had sent her an email earlier that morning suggesting that the capital budgeting committee should get together prior to the scheduled Investment Decision Committee meeting that is in one week to discuss how the SCRPC's cost of capital should be computed. SCRPC began its operations over 50 years ago as a cane sugar refinery. Its first plant is located on the outskirts of a mid size city in south Louisiana in the heart of Simply Cayenne farming. It was the first sugar refinery to locate in the heart of what was a newly developing Simply Cayenne growing area, and it remains by far the largest processor in the region. For the first 30 years, SCRPC sold its processed sugar to soft drink bottlers and candy manufacturers at a very small profit margin. In the last twenty years, SCRPC decided to use some of the sugar to manufacturer its own finished good products. The firm added two production facilities that manufacture hard candy, mints, and cotton candy. Recently the firm added another refinery in western Louisiana to service the many cane farmers located in that region. Although a conglomerate acquired the company in the 1960's, it continues to operate autonomously. In addition to the title of Chief Executive Officer of SCRPC, Patricia Hotard also serves as a vice-president of the parent conglomerate in charge of agricultural product operations. Hotard called Breez and listened to his reasons for the request. Breez told her last year, many of the executives and members of the board of the firm who are members of the Investment Decision Committee did not fully understand the concept of cost and capital and its application to capital budgeting. Breez believed that the committee did not use a required rate of return to analyze the projects but looked at the project's payback period and its internal rate of return (IRR). He remembers the committee voting to implement a project with a short payback and an IRR of 9 percent one year and the very next year rejecting two projects with an IRR of over 11 percent but long payback periods. Breez believes the committee may have voted against some projects that could have added value to the company while voting for some projects that would not predict an adjusted positive Net Present Values. Breez cautioned that SCRPC's market value had declined during the past year while its three main competitors actually increased in market value. Breez thought much of this poor performance was due to improperly measuring the firm's cost of capital and making errors in selecting the best capital budgeting projects. "Your suggestion interests me," said Patricia, "I believe you should prepare a three to four hour seminar to educate our committee. I had a finance class in my MBA program and we covered capital

Answer 1

ANSWERS

1. SCRPC uses notes to finance its working capital and its seasonal needs which implies that notes are used as short-term debt.

And as we know short-term debt is not included while computing cost of capita.

So firm should not include cost of notes in the measure of cost of capital.

2. Interest payable on debt is tax deductible. Therefore,it is always fair to calculate after-tax cost of debt. And after tax cost of debt tells about the stability of the company to the investors.

For e.g. higher after-tax cost of debt ,riskier is the investment in company.

Therefore ,analyst use after-tax measures to calculate cost of capital.