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1.
SIVMED's estimated weighted average cost of capital includes the following capital components cost of debt (kd), cost of common stock (kcs) and cost of preferred stock (kps). In computation of WACC the values should be after-tax because for instance the interest paid to obtain debt is tax deductible. For a firm that encountered losses the tax rate is zero, so the after-tax cost of debt equals the interest rate.
New (marginal) values should be used in computation of WACC because in financial management the WACC s used primarily to make investment decisions, and these decisions hinge on projects' returns vs. the cost of new capital. The historical cost is important to a certain extent the average cost of all capital raised in the past and still outstanding is used by regulators when they determine the rate of return a public utility should be allowed to earn, however the relevant cost is the marginal cost of new debt to be raised.
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a) The cost of debt (kd) is 6.6% as calculated below.
First, we have calculated Yield to Maturity by using a financial calculator and the YTM is 11% (5.5% semiannually)
Before-tax cost of debt is 11%
The tax rate is 40%
After-tax cost of debt is 11(1-.4) = 6.6%
b) Typically, when calculating the cost of debt, the flotation cost which is the cost incurred to sell new bonds, is disregarded. And this is, in a large content, due to the fact that the vast majority of debt is privately placed and hence has no flotation cost associated with issuing new bonds. Also, the adjustment for flotation costs usually has a very small effect on the cost of debt. There are some situations when the flotation cost should be considered in the after-tax cost of debt. First is when the floatation costs are a large percentage of the cost debt. The second situation is when the bond's life is short.
c) The nominal cost of debt should be used, which is 11%. The effective annual rate implies the following formula
(1+0.11/)-1= 11.%
Most companies use the nominal rate for all component costs because WACC is used to discount the capital budgeting cash flows. The capital budgeting cash flows are considered to occur at the end of the year. Using the nominal rate keeps the timing consistent for both the cash flows and the discount rate.
d) The 11% cost of debt (before tax) based on the current 15 years bonds is a fare estimate of a 0 years bonds. If the 15 years bonds would not be a good estimate of the new 0-year bonds, we could use the yield curve to further estimate the future interest rates on the 0-year bonds. The formula to calculate the yield curve is kd = krf + IP + DRP + LP + MRP. We based our consideration that the 15 years bonds is good a estimate for a 0 years bond on the fact that SIVMED's bonds are BBB rated and should bear a higher interest rate, due to the default risk premium, than long-term T-bonds or an average A rated bond. SIVMED's bonds bear 11% interest, T-bonds bear 8% interest and an average A-rated bond bears 10% interest.
e) In the case in which the SIVMED's outstanding debt has not been recently traded, there are other methods to estimate the cost of debt. One of these is the publicly traded debt of a similar firm that could be used as a reasonable estimate. The other method would be to contact an investment banker to evaluate the firm's debt and render an opinion on its cost.
f) Yes, it would matter if the bonds were callable. Callable bonds are redeemable by the issuing company before the maturity date. So, if market interest rates decrease, the company can call its bonds and reissue them at a lower interest. The yield to call interest rate should be used to estimate kd for callable bonds.
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a) The estimated cost of preferred stock (Kps) is .8% and is calculated below.
Kps = Dps/(Pn F)
= ($.5 x 4) / ($104.00-$.00) = .8%
Where
D- dividends
P-price
F-flotation cost
b) Companies like to own preferred stock because 70% of the received dividends are tax deductible. On the other hand the companies that raise capital through debt benefit from tax deductions on the interest paid. So, the cost of debt before-tax is higher then the cost of preferred stock. When the firm that issues the bonds receives the after-tax benefits of the deductible interest payments the after-tax cost of debt is lower than the cost of preferred stock.
c) If the preferred stock is redeemed in 5 years at a cost of $110.00, then the cost of preferred stock will be Kps=10.48%. We calculated this using a financial calculator and the following values N=0, PMT=$.50, PV= $104.00, FV=$110.00.
Silicon Valley Medical Technologies Cost of Capital
4.a. The cost associated with retained earning is the stockholders' opportunity costs. If all retained earnings are distributed to shareholders, they can reinvest the money in stock, bonds, real estate and so on. So, the earning retained by the company must earn at least as much as the investor's next best alternative forgone (of the same risk level) to satisfy the investors.
4.b. Using the CAPM approach, SIVMED's estimated cost of retained earnings (kre) is 15.%
kre = krf + ( RPm ) bi = .08 + (.06 1.) = 15.%
Here the market risk free rate krf = 8.0% (long-term T-bond rate)
The market risk premium RPm =6.0% (according to the investment-banking firm's estimates)
The firm's historical beta is 1..
4.c. There are three major reasons for using the T-bond rate as the risk free rate than the T-bill rate. First, most stockholders invest for a long-term basis. The inflation expectations of the T-bonds more accurately reflect the long-term expectations of the bondholders better than the expectations of the T-Bills. Second, Treasure bill rates are more volatile than are Treasure bond rates. Third, the CAMP is supposed to measure the expected return over a particular holding period (life of the project). Since most of the projects have long lives, therefore, the long-term T-bonds rate is a better choice for the risk-free rate.
If a project with a shortterm life or the market is more volatile and it's hard to predict, d the T-bill rates might be better estimate for risk-free rate.
4.d. Historical betas compare a company's stock returns against the market returns using historical data. Both the adjusted beta and the fundamental beta include adjustments to the historical beta to more accurately estimate the risk perceptions of the marginal investor. Adjusted betas correct a possible statistical bias in the historical beta by adjusting it to make it closer to the average beta of 1.0. A fundamental beta incorporates information about the company such as changes in product lines and capital structure.
SIVMED's historical beta is probably a worse measure of its future market risk than the historical beta for an average NYSE company would be for its future market risk. There are several reasons. First, SIVMED's has only three years of stock returns to compare against the market returns. On average most NYSE companies would have more years of data to compare that would yield a more accurate beta. Secondly, it has been stated that recently competition has become stiffer with many large biotech firms such as Genentech, Amgen, and Bristol-Myers realizing the opportunities available in SIVMED's market. As competition increases in the market, SIVMED may have a difficult time maintaining its market share and returns.
4.e. SIVMED can obtain a market risk premium for use in a CAPM cost of equity calculation through either in-house calculations or through external sources. If an external source is used, the company could consult a financial research firm or investment banker to estimate its market risk premium. If the estimate is created in-house there are two approaches that can be used historical or forward looking. Ibbotson Associates' historical risk premium study can be used to create the market risk premium using the historical approach. For the forward looking approach, there are several financial research firms that estimate the expected rate of return of the market based on discounted cash flows. These firms include Value Line, Zacks, and Institutional Brokers Estimate System (IBES). If the current T-bond rate is subtracted from this estimate, the result is a good estimate for the market risk premium.
5.a. Using the discounted cash flow (DCF) method, the estimate of SIVMED's cost of retain earning is 14.8 percent
kre = ( D1 / P0 ) + expected g
= ($1.0 1.10) / $5.00 + .10
= 14.8%
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5.b. Under the assumption that average return on equity is 14% and that 5% of retained earnings have been paid out as dividends, we can calculate g using the formula g = b (r).
g = .14 ( 1-.5)= 10.5%
Using this g to estimate ks would be 15. percent.
5.c. Historical dividend growth under the point-to-point method = 0.0
Historical dividend growth using linear regression = 0.0
6. Using the bond-yield-plus-risk-premium method, we get the estimate of SIVMED's cost of retained earning is 15.0 percent
kre = bond yield + risk premium
= 11.0 + 4.0 = 15.0%
The bond yield is calculated to be 11.0 in question number ;
The risk premium for the bond-yield-plus-risk-premium method is a judgmental estimate in the range of to 5 percentage points. We have used 4.0% as the risk premium.
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