Better Late Than Never

Kemal Inawel Marini Pisqa Arisanti

Situation Analysis

Oceantech Corporation, a Chesapeake, VA based company was incorporated in 1991. Founded By Ralph Torrence Oceantech was originally designed to provide ship repair services and quickly earned a Department of Defense (DOD) certified Alteration Boat Repair (ABR) designation The Firm opened and operated facilities in California, New Jersey, Florida, Maryland, Pennsylvania and Washington

Specialties of Oceantech Corporation

Structural Welding Piping System installation Repairs

Electrical

Painting

Rigging

Machinery and Dry Dock work

Custom sheet metal fabrication

Habitability Installation

Industrial Contracting Alteration/ Installation Teams (AIT)

Oceantech Corporation Balance Sheet ('000s)

Cash Accounts Receivables Inventory Total Current Assets Land & Buildings (net) Plant and Equipment (net) Total Fixed Assets 5000 Accounts Payable 10000 Accruals 20000 Notes Payable 35000 Total Current Liabilities 43000 Long-term Debt 45000 Common Stock 88000 (5 million shares outstanding) Retained Earnings Total Liabilities and Shareholders' 123000 equity 8000 5000 10000 23000 40000

50000 10000

Total Assets

123000

Oceantech Corporation Sales, Earnings, and Dividend History

('000s)
Year 1995 1996 1997 1998 1999 2000 2001 Sales $24,000,000 $28,800,000 $36,000,000 $45,000,000 $51,750,000 $62,100,000 $74,520,000 Sarnings per Share $0.48 $0.58 $0.72 $0.90 $1.04 $1.24 $1.49 Dividens per Share $0.19 $0.23 $0.29 $0.36 $0.41 $0.50 $0.60

Problem Statement

Up to now there is NO formal acceptance criteria in place to select the projects in the company, they just using gut feel approach which is couldnt be measurable and NOT always be accurate Howard therefore want to calculate the firms hurdle rate and use it in the future as the formal criteria to approve any projects, so the company will not make wrong decission

1. Why do you think Howard Sloan wants to estimate the firms hurdle rate? It is justifiable to use the firms weighted average cost of capital as the divisional cost of capital? Please explain

The hurdle rate for the firm represents the minimum rate of return that the firm as a whole must generate on its investments to satisfy its investors. This is sometimes referred to as the Weighted Average Cost of Capital (WACC) or simply the Cost of Capital. Howard Sloan wants to estimate the hurdle rate to know and measure: Type and mix of investors (equity, debt, preferred stock) Riskiness of the firm (riskier projects have higher rates) So the company can know which project is more profitable for them and should be taken by the company, so they will not choose wrong projects. A simple representation of the hurdle rate: Hurdle rate = Risk-Free Rate + Risk Premium We couldnt just use the WACC as the Divisional Cost of Capital esp. in multi-unit corporation like Oceantech Corporation, which each division should has different risk levels.

2. How should Roseanne go about figuring out the cost of debt? Calculate the firms cost of debt.
Before Tax Cost of Debt 1000 N d I n kd N d 1000 2

kd = before tax cost of debt I = annual interest in dollars Nd = Current value of bond excluding floatation cost n = years to maturity

After Tax Cost of Debt

K d k d (1 T )

Kd = after tax cost of debt kd = before tax cost of debt T = tax rate

Before Tax Cost of Debt: Annual Interest I = 10% x $1,000 = $100 Value of Bond Nd= (97.5% x $1,000) - $50 = $925 n = 25 years kd = [I + ((1,000 - Nd ) / n)] : [(Nd+1,000)/2] = [100 + ((1,000 - 925) / 25)] : [(925 + 1,000) / 2] = [100 + (75 / 25)] : [1,925/2] = 103 : 962.5 = 0.107 (10.7%) After Tax Cost of Debt: Kd = kd (1 T) = 0.107 (1 - 0.4) = 0.064 (6.4%)

3. Comment on Roseannes Assumptions as stated in the case. How realistic are they?
1. New debt would cost about the same as the yield on outstanding debt and would have the same rating PARTIALY AGREE -> Because the interest rate also can be changed, also for the tax rate, all depends on the economic condition The firm would continue raising capital for future projects by using the same target proportions as determined by the book values of debt and equity PARTIALY AGREE -> The target proportion of the capital maybe different for next projects, all according to the analysis of each cost, such as if the cost of debt became lower, the proportion of debt maybe can be higher than another The equity beta (1.2) would be the same for all divisions PARTIALY AGREE -> The equity beta of each division could be different because as a multiunit corporation, each division should has different risk level

2.

3.

4.

5.

6.

7.

The growth rates of earnings and dividends would continue at their historical rate PARTIALY AGREE -> This assumption was reasonable as the company was operating in a stable economic condition, and there is no high fluctuation in these years The corporate tax rate would be 40% PARTIALY AGREE -> This is quite realistic but actually it can be different according to market condition The floatation cost for debt would be 10% of the issued price and for equity would be 15% of selling price PARTIALY AGREE -> This is quite realistic but actually it can be different as floatation cost is not a fix cost therefore can be different according to the cost of each component when the service was given The first year treasury bill yield was 5% and the expected rate of return on the market portfolio was 12% PARTIALY AGREE -> This is quite realistic but actually it can be different according to market condition

4. Why is there a cost associated with a firms retained earnings?

Retained earnings are a component of equity, and there is a cost of equity/capital as already mentioned Firms retained earnings was owned by Stockholders, the cost of retained earning is simply the stockholders minimum rate of return which they should earn on same reserve. There should be a cost associated with retained earning because although this cost is not payable in the form of dividend, but in reality, the company is actually using shareholder funds because all earned profit should be payable as dividend but company is not paying full amount, so shareholders are deserve for getting return on reserved amount.

5. How can Roseanne estimate the firms cost of retained earnings?

A. Capital-Asset-Pricing-Model (CAPM) Approach Ks = rf + i (rm rf)
rf = Risk free rate i = Beta of the security rm= Expected market return

Ks = 5% + 1.2 (12%-5%) = 13.4%

B. Bond-Yield-Plus-Premium Approach
ks = cost of debt + risk premium = 6.4% + 5% = 11.4%

C. Discounted Cash Flow Approach /

Dividend Growth Model

ks = D1 + g P0

D1= next years dividend g = firms constant growth rate P0= price

g = (retention rate)(ROE) = (1-payout rate)(ROE) ---------------------------------------------------------g = (1- 0.4) (0.15) = 0.09 ->0.21 according to straight calculation (excel) ks = 0.73/25 + 0.21 = 0.24 (24%)

6. Calculate the firms average cost of retained earnings

By CAPM approach = 13,4% By Bond-Yield-Plus-Premium Approach = 11.4% By Discounted Cash Flow Approach = 24%

**The average = (13,4% + 24% + 11.4%) / 3 = 16,26%

8. How should Roseanne calculate the firms hurdle rate? Calculate it and explain the various steps
Projects the firm is considering must jump the hurdle, or in other words exceed the firms borrowing costs Borrowing cost is derived from Weighted Average Cost of Capital (WACC) In order to calculate WACC, the cost of the firms equity components (debt, common stock, preferred stock, retained earnings) must be calculated To get the final result, multiply the cost of equity components with their respective weight and add them together

Source of Funds Debt Common stock Retained Earnings Total

Amount

HURDLE RATE
39,000 0.23

Weights After Tax Cost 6.40% 13.40% 16.26% 36.06%

Weighted 1.472 9.648 0.613 11.733

125,000 8,800 172,800

0.72
0.05 1.00

Hurdle Rate

= Weighted Average Cost of Capital = (0.23*6.40) + (0.72*13.40) + (0.05*16.26)

= 11.933%

9. Can Howard assume that the hurdle rate calculated by Roseanne would remain constant? Please explain.
Howard can assume that the Hurdle rate would remain constant, but He also can assume that it will be different because:
The weight of each capital will NOT always be the same, according to shareholders adjustments refers to the market situation (which can give them higher return) ex. when the percentage of Cost of Debt lower than Cost of Common Stock the shareholder may prefer to take long term debt higher than common stock The rate of risks could be different depends on the market situation and development of technology The tax rate could be different according to Bank regulation and market situation The stock price may NOT always be the same, all depends on market situation and company performance The growth rate of the firm will not always be the same, it also depends on the market situation

THE END

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