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Finance Case Study: Chapter 13 Mini case- Sea Shore Salt

Based on Brinepool’s calculations and explanation, Bernice needs to clarify to him that the rate of return investors earn on the comparable risk investment in the capital market is the rate of return required to calculate for the cost of capital. Bob Brinepool’s estimate for the cost of equity should not be the rate of return shareholders demand for a risk free investment, but the target value for the book return on equity.

Examining the balance sheet reveals that the price of the preferred stock is not $100 but $70. The common stock is $40 per share with earnings of $4 per share. Thus, with this information, Bernice could compute the actual CAPM to get the accurate cost of equity. Doing this would result in a figure lesser than that obtained by Brinepool; that is, with the available information, the value of the preferred stock is $70×1 = $70.(Order a custom paper @ Discussionboardhomeworkhelp.com)

Other notable problems with Brinepool’s assessment includes the WACC estimates. To compute this figure, however, the value for the CAPM would require to be adjusted. Currently, the CAPM estimates indicate the correct value of the rate of equity as 11%. While this value is consistent with the rate derived from a scenario where there is a constant growth dividend using the dividend discount model, there is a need to consider the cost of equity, which in this case would be over the current rate of 11 percent. Thus, the cost of eqity is as follows:

Requity= (Div / P0 ) + g

= (2 / 40) + 0.067

= 0.117 or 11.7%

This figure concludes that the previous estimates of 11% were accurate.

Meanwhile, Brinepool’s estimates for the return on securities requires modifying to account for the expected returns offered to shareholders. The bond issue and bank loan offer pre-tax rates of 7.75% and 8% respectively, as indicated in the memo. Notably, however, the preferred stock is selling under par. Hence, the CEO is wrong to assume that the rate on preferred stocks is 6%. The return on preferred stocks selling at $70 per share is:

Rpreffered= (Div / P0 )

= 6 / 20

= 0.086 or 8.6%

This new figure is accurate since the pre-tax return on preferred shares should exceed the company’s debt.

Notable errors in the calculations by Bob Brinepool include the calculations on the rate of the bank loan and the bond issue. Based on the provided information below are the correct calculations for the various rates. (If you need a similar paper, contact buytermpaper online).

Previous tax rate on bank loan = 8%

Previous tax rate on bond issue = 7.75%

Correct tax rate on the bank loan = 8% x (1-0.35)

= 5.2%

Correct tax rate on the bond issue = 7.75% x (1-0.35)

= 5%

Other considerations to make regarding the submission by Bob Brinepool are on the WACC estimates. Ideally, the weights used to calculate the WACC are required to reflect the market and not the rates indicated in the accounting records. In addition, the computation for WACC should take to account the market values rather that the book values. For this reason, the information provided by the Sea Shore Salt should be applied, considering the bond issue and bank loan amounts remain unchanged and thus retain the pretax rates of 7.75 and 8%, respectively. These weights are the costs borne by investors to acquire assets. Hence, the market value weights should be as follows:

 NotesAmount

(millions)

Total percentageRate of return
Bank loanValue at face$12017.918%
Bond issueValue at par$8011.947.75%
Preferred stock1million shares at $70$7010.458.6%
Common stock10 million shares at $40$40059.7011.7%
  $670100 

Given the above, Sea Shore Salt WACC is:

WACC = [0.1791 x 8% x (1 – 0.35)] + [0.1194 x 7.75% x (1 – 0.35)] + (0.1045 x 8.6%) +(0.5970 x 10.5%) = 8.70%

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