38111426 Case 33 Presentation

Case 33Cost of Capital Considerations

TOURING ENTERPRISES

TOURING ENTERPRISES

Touring Enterprises began in 1970 as a mail-order house for motorcycle parts and accessories such as parts to do-it-yourself repairpersons and sales of outerwear.

STATEMENT OF THE PROBLEM

Main Problem:What policy should Touring Enterprises develop on calculating the cost of capital that would require careful consideration of the current liabilities?

STATEMENT OF THE PROBLEM

Specific ProblemsWhat are the firm’s sources of capital? Does it include the

current liabilities?

What are the costs of the firm’s specific type of capital?

What is the firm’s capital structure?What are the economic circumstances that could affect the

firm’s optimal capital structure?

What is the firm’s Weighted Average Cost of Capital?

STATEMENT OF THE OBJECTIVE

Main Objective:To determine the appropriate policy that Touring Enterprises should develop on calculating cost of capital that would require careful consideration of current liabilities.

STATEMENT OF THE OBJECTIVE

Specific Objectives:To identify the firm’s sources of capital and to know if it

includes current liabilities and depreciation

To calculate the costs of each specific type of capital

To identify the firm’s capital structureTo know the economic circumstances that could affect the

firm’s optimal capital structure

To determine the firm’s weighted Average Cost of Capital

POINT OF VIEW

The case of Touring Enterprises is analyzed using the point of view of Ed Mettway, the treasurer and chief financial officer (CFO) of the company.

AREAS OF CONSIDERATION

1. After-tax Cost of Debt, Kd (1-T)

It is the relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate the WACC.

2. Cost of common stock equity, Ks

It is the rate at which investors discount the expected dividends of the firm to determine its share value.


3. Current liabilitiesShort term liabilities that are expected to be paid within one year or less

4. Capital structureIt is the mix of long-term debt and equity maintained by the firm.


5. Book value weights Weights that use accounting values to measure the

proportion of each type of capital in the firm’s financial structure.

6. Historical weightsEither book or market value weights based on actual capital structure proportions.

7. Optimal Capital StructureIt is the capital structure at which the weighted average cost of capital is minimized, thereby maximizing the firm’s value.


8. Weighted average cost of capital (WACC)It reflects the expected average future cost of funds over the long run. It is found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure.

PRESENTATION AND ANALYSIS

ALTERNATIVE1: Status Quo (question 5)

Touring Enterprises finances its acquisition of capital in the long-term through long-term debt and common stock equity which is raised by retaining the firm’s earnings (internal equity).

Cost capital calculation focuses only on long-term sources financing in that short-term sources such as current liabilities are not included.


Given:Annual Dividend = $1.10Yield on debt (Kd) = 7.5%

Present Stock Price (P0) = $22

Marginal tax rate (T) = 35%


After-tax cost of debt = Kd x (1 – T)

= 7. 5% x (1-.35)

= 7.5% x .65

= 4.875%

= 4. 88%


Cost of Retained Earnings (Kr) = + g

= ($1.10/$22) + 0

= .05 + 0

= .05

= 5%


Weight of Debt (Wd) =

=

=

= .25035

= 25.034%

Weight of Equity (WE) =

=

= .74924

= 74.92%


SOURCE OF CAPITAL (1)

WEIGHT (2) COST (3) WEIGHTED COST (2)x(3)

Debt .25035 4.88% 1.222%

Equity .74924 5% 3.746%

WACC 4.968%


ALTERNATIVE2: Including current liabilities in capital cost calculation

Long-term liabilities carry an interest cost explicitly. Since there are no “free lunches” in this world, all of liabilities that do not carry an explicit cost must surely have an implicit cost. It is assumed that the before-tax cost of current liabilities would be 6% which should be lower than the interest on long-term debt.


Sources of Financing Before-tax cost of debt

After-tax cost of debt

Current Liabilities 6% 6% (1-.35) = 3.9%

Long-Term debt 7.5 7.5% (1-.35) = 4.88

Common equity 5 5


Sources of Financing Weight of each specific type of capital

Current Liabilities Weight for current liabilities = Current Liabilities/Total Capital

= $5123/$23,497

=0.21803 or 21.803%

Long-Term debt Weight for long-term debt = Long-term debt/ Total Capital

= $4600/$23,497

= .19577 or 19.577%

Common Equity Weight of common equity = Common equity/Total capital

= $13,744/$23,497

=.5862 or 58.62%


SOURCE OF CAPITAL (1)

WEIGHT (2) COST (3) WEIGHTED COST (2)x(3)

Current Liabilities .21803 3.9% .85032

Debt .19577 4.88% .95536

Equity .5862 5% 2.931

Weighted Average Cost of Capital

(WACC)

4.73668%


Economic Considerations (question 8):1. Recession (inflation)

It lowers the business confidence of the investors so they would demand for a higher required rate of return, therefore affecting the cost of debt.

2. Economic BoomDemand for funds increases, lenders and financiers increase their lending rate which will also increase a firm’s cost of capital.


The resulting WACC in alternative 2 is 4.74%. The calculation of cost of capital in this alternative includes the current liabilities. This WACC appears to be lower than the WACC of the status quo, which is 4.97%, but it doesn’t mean that the firm should follow this method of calculation.

CONCLUSION:

Since current liabilities are part of short-term financing and are used to calculate the firm’s net working capital, Touring Enterprises should not consider current liabilities as part of its permanent financing. The firm’s concern is with only the long-term sources of funds available to them, because these sources supply the permanent financing (question

10).

RECOMMENDATION:

It is logical to recommend to Ed Mettway to develop a policy on calculating the firm’s cost of capital that does not include current liabilities.

Documents

38111426 Case 33 Presentation