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Better Late Than Never… Kemal Inawel Marini Pisqa Arisanti OCEANTECH CORPORATION
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Page 1: Better Late Than Never

Better Late Than Never…

Kemal InawelMariniPisqa Arisanti

OCEANTECH

CORPORATION

Page 2: Better Late Than Never

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

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Specialties of Oceantech Corporation

Structural Welding

Piping System installation Repairs

Electrical Painting Rigging

Machinery and Dry Dock

work

Custom sheet metal

fabrication

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Other Divisions of Oceantech

Habitability Installation

Industrial Contracting

Alteration/ Installation Teams (AIT)

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Oceantech CorporationBalance Sheet

('000s)Cash 5000Accounts Payable 8000Accounts Receivables 10000Accruals 5000Inventory 20000Notes Payable 10000Total Current Assets 35000Total Current Liabilities 23000 Land & Buildings (net) 43000Long-term Debt 40000

Plant and Equipment (net) 45000Common StockTotal Fixed Assets 88000(5 million shares outstanding) 50000

Retained Earnings 10000

Total Assets 123000Total Liabilities and Shareholders' equity 123000

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Oceantech Corporation

Sales, Earnings, and Dividend History

('000s)Year Sales Sarnings per Share Dividens per Share

1995 $24,000,000 $0.48 $0.19

1996 $28,800,000 $0.58 $0.23

1997 $36,000,000 $0.72 $0.29

1998 $45,000,000 $0.90 $0.36

1999 $51,750,000 $1.04 $0.41

2000 $62,100,000 $1.24 $0.50

2001 $74,520,000 $1.49 $0.60

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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 couldn’t be measurable and NOT always be accurate

• Howard therefore want to calculate the firm’s hurdle rate and use it in the future as the formal criteria to approve any projects, so the company will not make wrong decission

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1. Why do you think Howard Sloan wants to estimate the firm’s hurdle rate? It is justifiable to use the firm’s 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 couldn’t 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.

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21000

1000

d

d

d NnN

Ik

2. How should Roseanne go about figuring out the cost of debt? Calculate the firm’s cost of debt.

• kd = before tax cost of debt• I = annual interest in dollars• Nd = Current value of bond

excluding floatation cost• n = years to maturity

• Before Tax Cost of Debt

• After Tax Cost of Debt

)1( TkK dd • Kd = after tax cost of debt• kd = before tax cost of debt• T = tax rate

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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%)

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3. Comment on Roseanne’s 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

2. 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

3. 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 multi-unit corporation, each division should has different risk level

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4. 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

5. The corporate tax rate would be 40% PARTIALY AGREE-> This is quite realistic but actually it can be different according to market condition

6. 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

7. 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

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4. Why is there a cost associated with a firm’s retained earnings?

• Retained earnings are a component of equity, and there is a cost of equity/capital as already mentioned

• Firm’s 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.

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5. How can Roseanne estimate the firm’s cost of retained earnings?

A. Capital-Asset-Pricing-Model (CAPM) Approach

Ks = rf + βi (rm – rf) rf = Risk free rateβi = Beta of the securityrm= 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%

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C. Discounted Cash Flow Approach / Dividend Growth Model

ks = D1 + g P0

g = (retention rate)(ROE) = (1-payout rate)(ROE)

D1= next year’s dividendg = firm’s constant growth rateP0= price

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

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6. Calculate the firm’s 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%

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7. Can floatation costs be ignored

in the analysis? Explain.

• Floatation Costs are the cost of service of investment

banker as they provide some services like:

– Setting the price on the issue

– Selling the issue to the public

• The cost can NOT be ignored, but should be accounted

for in the WACC

• Generally we do this by reducing the proceeds from the

issue by the amount of the flotation costs and

recalculating the cost of capital

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• Projects the firm is considering must “jump the hurdle”, or in other words exceed the firm’s borrowing costs

• Borrowing cost is derived from Weighted Average Cost of Capital (WACC)

• In order to calculate WACC, the cost of the firm’s 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

8. How should Roseanne calculate the firm’s hurdle rate? Calculate it and explain the various steps

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Source of Funds Amount Weights After Tax Cost Weighted

Debt 39,000 0.23 6.40% 1.472

Common stock 125,000 0.72 13.40% 9.648

Retained Earnings8,800 0.05 16.26%

0.613

Total 172,800 1.00 36.06% 11.733

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

= 11.933%

HURDLE RATE

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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

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THE END

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