Case 30: Taylor Brands

1. It does seem appropriate that the degree of operating leverage will decrease because if
West intends to adjust Taylor’s beta downward.The Degree of operating leverage has an
affect on systematic risk thus making it effect the beta. Because of it the market risk rate
will also decrease because of it.

2.)
a.) Risk free rate - 7% , Risk Premium - (12.1% - 4.9%) 7.2%, Beta - .8
Ke = Rf + (Rm-Rf)*B
Ke = .07 +(.072)*.8
Ke = .1276 12.76%

b.) Ke= (D1/P0) + g

P0= (28+36)/2 = $32

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D1= $2.05

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g= .3*.12=.036

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Ke= (2.05/$32) + .036 = 0.1001 10.01%

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c.) Ke or Cost of equity is the return the firm pays to its equity investors. This payment is

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to compensate investor/shareholders for the risk they take on and is usually represented
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as a percentage. So 12.76% based on CAPM
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3.) Required Return Debt = .07 (1-.4) = 4.2%
Required Return Bond = .08 (1-.4) = 4.8%
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Required Return Equity = 12.76%

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Notes Payable 16,000 7%

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Bonds 89,000 38%

Equity 130,000 55%
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WACC = .07(.042) + .38(.048) + .55(.1276)

WACC = 9.14%
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4.) This may be due to the preferential tax treatment the dividends receive. Preferred stock
purchased by companies have dividends that are for the most part tax exempt. This may
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suppress yields which is a negative for individual investors. However, investors mainly look at
the after-tax return of preferred stock and bonds; if the yield for both were adjusted for taxes,
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preferred stock would most likely have higher returns.

7.)
a.) The market value of the notes payable should be close to the book value. Market
price of notes payable does not fluctuate much with interest rates due to short term of
maturity on notes.

b.) MV= 3,115 * 13.59 + 89,000 / (1.04)^20

MV= $82,951

c.) MV/BV = 1.15, Common Stock 58,000 +72,000 retained earnings

Market Value of Stock = 1.15*(130,000)

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 Market Value of Stock = $149,500

d.) Market Values Weight

Notes 16,000 6.4%
Bonds 82,951 33.4%
Equity 149,500 60.2%

WACC = (.064*.042) + (.334*.048) + (.602*.1276)

WACC = 9.6%

8.)
a.) Market Values are better to determine the firm's cost of capital because the value is
relative to the current rate placed on its stocks/bonds. Book value is determined based
on historical data from a firm’s balance sheet thus making it less accurate because it’s
old data.

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b.) Utilizing book values are easier to use because all information is readily available

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since it uses previous period data. The other perk is that book values do not fluctuate

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the way market values do.

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9.)
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a.) Some difficulties the company could run into is that it would make determining if a
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project should be undertaken or not. This could lead to many projects not
happening that should and many that happen that shouldn't. Additionally with such a
high hurdle rate projected cash flows would be over inflated by supporters of particular
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projects just so they are approved.

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b.) By having a more accurate cost of capital estimate it should not reduce bias, it will
however give decision makers a more accurate view of the project. There will of course
be less pressure on biased managers to over inflate their cash flows for project approval.
The numbers may not be so inflated and will allow decision makers with more accurate
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information.

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