Please explain how to make proper calculations. The rates of return on the bank
ID: 2707684 • Letter: P
Question
Please explain how to make proper calculations.
The rates of return on the bank loan and bond issue are of course just the interest rates we pay. However, interest is tax-deductible, so the after-tax interest rates are lower than shown above. For example, the after-tax cost of bank financing, given our 35% tax rate, is 8(1 - .35) = 5.2%. The rate of return on preferred stock is 6%. Sea Shore Salt pays a $6 dividend on each $100 preferred share. target rate of return on equity has been 16% for many years. I know that n-"comers think this target is too high for the safe and mature salt business. But we must all aspire to superior profitability. Once this background is absorbed, the calculation of sea shore salt's weighted-average cost of capital (WACC) is elementary: WACC = 8(1- .35) (.20) + 7.75(1- .35) (.133) + 6(.167) + 16(.50) = 10.7%. If you have further questions about these calculation, please direct them to our new Treasury Analyst, MS. Bernice Mountaindog. It is a pleasure to have Bernice back at sea shore salt after a year's leave of absence to complete her degree in finance. Bernice first examined Sea Shore Salt's most recent balance sheet, summarized in Table 13,6. Then she jotted down the following additional points; The company's bank charged interest at current market rules, and the long-term debt had just been issued. Hook and market values cirnld not differ by much. But the preferred stock had been issuer! 35 years ago, when interest rates were much lower. The preferred stock, originally issued at a book value of SIIX) per share, was now trading for only $70 per share. The common stock traded for MO |>cr .share. Next year's earnings per share would lie about $4 and dividends |H*r share probably $2. (10 million shares of common stock are outstanding.) Sea Shore Salt had traditionally paid out 50% of earnings as dividends and plowed back the rest. Earnings and dividends had grown steadily at 6% to 7% per year, in line with the company's sustainable growth rate: 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 (C'AI'M). With current interest rates of about 7%, and a market risk premium of 7%. CAP'M cost of equity = rE= r1 + Beta (rm-rf) = -- 7% + .5(7%) = 10.5% This cost of equity was significantly less than the 16ft decreed in Mr. Brinepool's memo. Bernice scanned her notes apprehensively. What if Mr. Brincpool'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. Notes: At year-end 2010, Sea shore salt had 10 million common shares outstanding. The company had also issued 1 million preferred shares with book values of $100 per share. Each share receives an annual dividend of $6.Explanation / Answer
we Hve g = 6.7% , D1 = 2 & Po= 40
Using Gordon Model, we have
P0 = D1/(Ks-g) where Ks is cost of equty
So Ks = D1/P0 + g = 2/40 + 6.7% = 11.70%
SO Using Gordon Model, we have Ks = 11.70%
& Usig CAPm, we have Ks = 10.50%
To calculate a company