The Specific Items of Capital

1. What specific items of capital should be included in the SIVMED’s WACC? Should before-tax or after-tax values be included? Should historical or new values be used? Why? Answer: WACC covers computation of SIVMED’s cost of capital in which each category of capital is proportionately weighted. All capital basis - common stock, preferred stock, bonds or any other long-term borrowings – should be listed under SIVMED’s WACC. We determine WACC by multiplying the cost of the corresponding capital component by its proportional weight and then adding: where: Re is a cost of equity Rd is a cost of debt E is a market value of the firm's equity D is a market value of the firm's debt V equals E + D E/V is a proportion of financing that is equity D/V is a proportion of financing that is debt Tc is a corporate tax rate Broadly speaking, SIVMED’s assets are financed by the choice of debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, SIVMED can determine how much interest the company has to pay for every dollar it uses. Shareholders are interested into cash flows available to them, after corporate taxes have been paid. Consequently, we have to use After-Tax WACC. The cost of capital is used above all to make decisions that involve getting new capital. Hence, the applicable component costs are present marginal costs but not than historical costs. 2. What is your estimate of SIVMED’s cost of debt? a. The cost of debt is the money company has to pay for using the funds. In our case, annual cost of debt is kd: kd/2 = r = 5.0%. kd/2 = (47.5 + [1000-891] / 30) / ((2*891 + 1000) / 3) = 5.5% We have to multiply this by 2 since we are dealing with semiannual payments, hence annual yield is 11%. Because interest is tax deductible, government pays part of the cost, and our component cost of debt is the after tax cost: kd (1-T) = 11% (1-0.4) = 11 * 0.6 = 6.6% b. Should flotation costs be included in the component cost of debt calculation? Flotation costs are typically included in the component of debt calculation as a part of calculating the nominal rate of the debt’ cost. The costs related to the process of getting new securities. Flotation costs cover both the underwriting spread and the costs paid by the issuing company from the offering. Shown as a portion of gross proceeds, costs usually rise as risks associated with the issue rise, or the size of the offering decreases.

c. Should the nominal cost of Debt or the effective annual rate be used? Since the bond pays a coupon semi-annually, and earns 4.75% in six months, it is possible to determine the effective annual rate (EAR), which we have successfully calculated above. EAR = 6.6% Nevertheless, nominal rates are typically used for the cost of debt, because total costs of issuance and sale of securities decrease the net proceeds from the sale. These costs are naturally small on public debt issues. d. How valid in an estimate of the cost of debt based on 15 year bonds if the corporation normally issue 30 year long term debt? The estimate is not exactly valid because coupon rates differ for 15- and 30-year bonds. Generally, the cost of debt is higher for bonds with longer time to maturity. It has to do with risk. The longer the time to maturity, the higher the risk, hence, the higher the coupon rate (cost of debt in our case). In order to make the estimate more valid, the yield curve calculated for the 15-year bonds have to be adjusted for the 30-year bonds. e. Suppose SIVMED’s outstanding debt has not been recently traded, what other methods could be used to estimate the cost of debt? To determine the cost of debt for for the debt that has not been traded, we would calculate a synthetic rating based upon the company's financial ratios. In its most basic form, we are able to determine a synthetic rating for a company based upon its interest coverage ratio. By determining a default spread based upon this synthetic rating and adding it to the risk-free rate, we are able to estimate an updated pre-tax cost of debt for this company. While many specialists assume that book debt is equal to market debt to get over the fact that most debt is not traded, there is a logical approximation that we can use to estimate market value of debt. Think about the book debt to be the the same of a coupon bond, with the book value of the debt representing face value, the interest payments covering the coupon and the weighted average maturity of the debt showing the maturity of the bond. Employing the pre-tax cost of debt from the synthetic rating as the interest rate, we are able to determine the market value of this bond. f. Would it mater if the currently outstanding bonds were callable? Yes, it would matter, because with callable bonds the company has an opportunity to reduce its cost of debt if the interest rates fall.

Callable bond is a bond that can be bought back by the issuer before to its maturity. Typically a premium is paid to the bond owner when the bond is redeemed. With callable bonds, the firm will redeem its current bonds and reissue them at a lower rate of interest. 3a. What is your estimate of the cost of preferred stock? Cost of Preferred stock = Dividend / (Price – Underwriting Costs) Hence, Cost of preferred stock = 10 / 102 = 9.8% Preferred dividends are not tax deductible, therefore there is no tax adjustment. b. Answer: Companies own most preferred stock. The reason being is that 70% of preferred dividends are nontaxable to corporations. Hence, preferred stock typically has a lower B-T yield than debt. c. Cost of PERC = 10 (annual dividend) / (102 (adjusted trading price) – 10 (the stock is to be redeemed at 110 and it was issued at 100). Hence cost of PERC = 10.8% -s higher than cost of regular preferred stock 4a. Answer: Earnings of the company can be reinvested or paid out as dividends. Shareholders may use dividends to buy other securities and earn a return. Hence, there is an opportunity cost if earnings are kept. Opportunity cost is the amount or percentage of return investors would earn on alternative investments of proportional risk. What is more, these shareholders, could buy similar stocks and attain profit, or the firm could repurchase its own stock and earn profit. So profit (RE)is the cost of retained earnings. b. Answer: Ks = Krf + B ( Km - Krf), where • Ks = The Needed Rate of Return, (or simply the rate of return). • Krf = The Risk Free Rate (the rate of return on a "risk free investment", such as the U.S. T-Bonds ) • B = Beta • Km = The anticipated return on the overall stock market. Hence, Ks = 8% (T-Bonds) + 1.2 * (14% - 8%) = 15.2% c. T-bond rate might be considered to be a better estimate of the risk-free rate because of longer maturity terms of T-bonds (more than 10 years) and regular payments made to the holder of T-bond. T-bill is a short-term debt obligation supported by the U.S. government with a maturity of less than one year. T-bills are distributed in denominations of $1,000 up to a maximum purchase of $5 million and typically have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). T-Bond – is a marketable, steady-interest U.S. government debt security with a time to maturity of longer than 10 years. The bonds provide interest payments semi-annually and the income that holders egt is only taxed at the federal level.

d. Answer: Beta - A measure of the volatility of a security or a portfolio in contrast to the market as a whole. Historical beta - the past standard deviation of a security that is employed in security analysis. Standard deviation measures the alterations in the historical price of a security. Generally, the higher the standard deviation the more unstable the security. Adjusted historical beta – historical beta adjusted for market conditions. Fundamental beta – beta adjusted for Information relating to the economic well-being of a company such as revenue, earnings, assets, liabilities and growth. e. Answer: Market risk premium – is calculated as the difference between the expected return on a market portfolio and the risk-free rate. There are a few ways to determine the market risk premium. A. Consult with the industry analysts such as investment bankers or equity specialists, they usually provide a well-grounded data on these subjects. B. Use CAPM model to solve for the market risk premium. C. Future calculation by financial analysts of market minus T-bond. 5a. Answer: P0 = (D0 * [1 + g]) / (RE %uF02D g), Hence, RE = ((D0 * [1 + g])/ P0)+ g RE = ((1.09 * [1 + 0.1])/ 25)+ 0.1 = 14.8% b. Answer: One has to solve for g in the DCF formula using the information provided. In our case, the RE is 14%, however, because the D1 is unknown, it is difficult to solve for g. c. Answer: Using the point to point method, the firm’s historical dividend growth was: 1996: 4%, 1997: 13% 1998: 18% 1999: 9%. Using the liner regression method, the firm’s historical dividend growth was: Y = kx + b, we are interested in k here since it is our line’s slope and it shows the g rate. Hence, the g was about 11.4% 6. Answer: Bond-Yield-Plus-Risk Premium method, ks = kd + RP, ks = bond yield + risk premium = 8% + 6% = 14% 7. Answer: Method Estimate CAPM 15.2% DCF 14.8 kd + RP 14.0 Average 14.7% At this point, substantial judgment is needed. If a method is thought to be inferior due to the “quality” of its inputs, then it might be given little significance or even disregarded. In our case, though, the three methods produced fairly close results, so we used the average, 14.7%, as the estimate for our cost of retained earnings.

8. Answer: The DCF method gave an estimate for the cost of retained earnings of ks = 14.8% (refer to the calculations given earlier in the paper). However, flotation costs of 30% must be taken in our case, and that raises the cost of equity to 16.9%: ke = D0 (1+g) / P0 (1-F) +g, hence, ke = 1.09 * 1.1 / 25 (1-0.3) + 0.1 = 16.9% We can see that flotation costs lifted the cost of equity by 2.1%: Flotation adjustment = 16.9% 14.8% = 2.1%. 9a. Answer: WACC = 14.7% (using the average of three methods) * 0.6 + 9.8% * 0.1 + 6.6% * 0.3 = 11.78% A marginal cost of capital (MCC) schedule is simply a plot of the firm’s WACC against dollars of new capital acquired. Here is our MCC schedule: The plot is titled the marginal cost of capital (MCC) schedule since it illustrates the cost of each additional, or marginal, dollar raised (the marginal cost). b. Answer: As more new capital is needed in any year, our WACC would eventually begin to increase above 11.78%. The firm would have to get new buyers for its debt, preferred, and common stock, and those new customers would need higher rates of return to be motivated to invest in our securities. What is more, predominantly large capital investment programs probably would increase Coleman’s perceived riskiness, because investors would become very concerned about management’s ability to direct such rapid growth efficiently. Most companies do not try to quantify the MCC precisely early in the planning process. However if they consider that extraordinarily large amounts of capital will have to be get, they do adjust the WACC upward. c. Answer: Depreciation doesn’t affect the equity value, however, depreciation affects such values as operating profit and value of the company’s assets. If the depreciation is ignored, the Net Income calculations will be erroneous. 10a. Answer: The corporate cost of capital should be used by both division, however, adjustments for market risk, volatility (different industries have different betas), and project’s peculiarities should be made. 11a. Answer: (Book Value WACC) Debt = 61.2 / 155.7 = 39% Preferred Stock = 15 / 155.7 = 10% Common Stock = 79.5 / 170.8 = 51% 2. Answer: (Market Value WACC) Debt = 30% Preferred Stock = 10% Common Stock = 60% C. Answer: Weighted Average Cost of Capital determines marginal cost of issuing new securities to finance projects. Such securities should be issued at market value. Therefore weights allocated to debt and equity in determining WACC should be based on market value.