ADMS 2400 Lecture 33: ADMS 2400 Lecture 33 Notes

Taylor Brands

Cost of Capital or Required Rate of Return

The management of Taylor Brands has a philosophy of "better to be safe than sorry" when selecting a discount rate. At present the firm uses a 30 percent rate, which many company executives feel is unreasonably high and results in the following difficulties. First, some projects considered to be worthwhile and important are rejected because their expected return is close to, but still below, the 30 percent minimum. Second, managers have a tendency to be overly optimistic in their cash flow projections in order to get their pet projects accepted. Third, there is the feeling that the rate is at best arbitrarily determined and at worst something that Trevor Unruh-Taylor's general manager-has "pulled out of a hat."

ROBERT WEST

Robert West is one of Taylor's more innovative and thoughtful executives. A few years ago he correctly perceived that a successful firm in the food wholesalers industry-Taylor's main industry-would have to expand into nonfood items. After extensive study, West recommended that Taylor add such products as light hardware and paper plates to the variety of goods it sells to grocery stores. This strategy worked remarkably well. Taylor's customers benefited because they dealt with fewer vendors and invoices. Taylor gained customers (many were referrals) and also reduced its unit cost by making more efficient use of its trucking capacity.

West has developed an interest in the financial side of the business. During the past year he attended two seminars on cost-of-capital estimation, using his personal leave time and at his own expense. He has been eager to apply this newly acquired knowledge, and after a number of discussions Unruh told West to "determine Taylor's cost of capital and make a formal report on your findings." It seemed to West that this was a major coup since Unruh paid little attention to the financial side of the business. He was told privately, however, that Unruh is "really unimpressed and bored with the entire idea; he assigned you this project because he knew that you were eager to do it, and Unruh admires your initiative." West was told quite bluntly that "nothing will come of your efforts."

Initially deflated, West became determined to do a thorough evaluation, and he felt sure that he could convince Unruh of the importance of obtaining an accurate cost of capital. "At the very least," West thought, "a formal investigation of our cost of capital will eliminate the perception that it is arbitrarily determined."

In preparation for making the estimate West reviewed his notes from one of the seminars he had attended. (See Exhibit 1.) He recalled the instructor emphasizing that estimating the required return on equity was especially delicate; and although the instructor gave two models for measuring this return, he emphasized there was "no substitute for good judgment."

FINANCIAL INFORMATION

West also collected some financial information that he felt was relevant to the analysis. He knows the company has recently obtained a bank note at 7 percent and that the company's bonds were originally issued at 7 percent but are currently selling at a discount with a yield to maturity of about 8 percent.

Taylor's EPS has grown quite impressively in the last five years (see Exhibit 3), but West knows Unruh encouraged a relatively constant dividend per share over this period since he preferred to reinvest much of the company's earnings. West doesn't believe this will continue since Unruh is under pressure from major stockholders to bring dividend growth in line with earnings growth. Nor is it likely that past EPS growth can be maintained. First, during this period the industry itself had unusual prosperity. Second, some of this past growth was a result of the firm's movement into nonfood items, and these opportunities are virtually exhausted. Third, many corporate insiders felt Taylor had been a bit lucky.

West decides it is reasonable to suppose that Taylor will implement a 70 percent payout ratio; after all, it makes no sense to retain a large proportion of earnings when investment opportunities are not as plentiful as in the past. He also feels that the company will achieve an average return of 12 percent on any retained earnings. Though these figures on payout and return are something of "guesstimates," West was able to find support for these numbers among Taylor's managers.

Most financial analysts consider the industry to be of average risk, and in fact, beta estimates for Taylor range from .8 to 1.2. West decides, however, that these estimates are a bit high, because the firm is in the process of altering production techniques that will reduce the company's degree of operating leverage.

And there is another difficulty. At present Taylor has no preferred stock in its capital structure. But West knows that there are plans to issue some in the next few months, though the price and dividend per share have not yet been determined. However, he does have some information on the preferred stock of three of Taylor's competitors. (See Exhibit 6.) These companies are much larger than Taylor and are considered less risky because they have a more diversified product line and customer base and enjoy a lower degree of operating leverage (even after the change in Taylor's production techniques). He is also aware that the yield difference on the preferred stock of firms in roughly the same industry is 75 to 100 basis points.

"I've got quite a bit of info," West thought. "I hope I can put it all together to make a report that will impress Unruh."

EXHIBIT 1

Excerpts from West's Notes on the Cost of Capital Seminars

1. The instructor said the cost of capital is really the required rate of return or hurdle rate that should be used to evaluate capital budgeting projects of average risk for the company. (Indeed, he much prefers the term "required rate of return" to the more common but potentially misleading "cost of capital.")

2. The cost of capital is a weighted average of the required return on each financing source. Theoretical accuracy requires these weights be obtained at the market values of debt, equity, and (if applicable) preferred stock. The instructor said, however, that most firms use book values because (1) it is easier, and (2) market values tend to vary widely.

3. The instructor recommended that all debt that does not require an explicit return be excluded when calculating the weights described in part 2. (Usually this means excluding accounts payable and accruals.)

4. The required return on each financing source should be based on current market conditions.

5. The instructor recommended that flotation costs be ignored. While theoretically incorrect this omission simplifies the calculations and does not significantly alter the estimate.

EXHIBIT 2

EXHIBIT 3

EXHIBIT 4

EXHIBIT 5

EXHIBIT 6

Please Answer 1, 2a, 2b, 4, 6, 7d, 9a, 9b, 10a, 10b

Question 1

West intends to adjust Taylor's beta estimates slightly downward in view of the fact that the firm's degree of operating leverage is decreasing. Does such an adjustment seem appropriate? Explain.

Question 2

The required return on equity (cost of equity), Ke, can be estimated in a number of ways.

(a) Estimate Ke using a risk premium approach.

(c) In your view, what is Ke? Justify your choice.

Question 4

Preferred stock is a riskier investment than a bond. Yet companies have been known to issue preferred stock at a lower yield than they issue bonds. How can this be, assuming investors are rational?

Question 6

What additional information would you like in order to make more informed estimates about the cost of equity and the cost of preferred stock?

Question 7

(d) Estimate Taylor's cost of capital or required return assuming that these market values are consistent with the financing weights desired by management. (You may ignore preferred stock.)

Question 9

(a) Apparently the 30 percent hurdle rate used by Taylor exceeds its actual cost of capital or required rate of return. Let us suppose a company errs in the other direction and chooses a hurdle rate considerably less than its actual cost of capital. What difficulties could this cause?

(b) West believes that Taylor’s high cost of capital encourages managers to develop overly optimistic cash flow forecasts. Is a more accurate cost-of-capital estimate likely to reduce this bias, as he apparently thinks? Explain your answer.

Question 10

(a) Suppose that West will present a summary of his findings to senior management. Would you recommend that he presents his estimate or Taylor’s required return (cost of capital) as XX percent, XX.X percent or XX.XX percent? That is, how- if at all- would you suggest the estimate be rounded off? (Keep in mind that he is likely to be questioned thoroughly by Unruh, who appears skeptical of West’s efforts.)

(b) Would you recommend that West use market or book values in his presentation? Defend your recommendation.

Carter Company (A)

Dubuque, Iowa

In December 2006, Jacob Carter, owner of Carter Company (CC), finalized a new sales contract with John Deere Company (JDC). With his 40 years of experience in manufacturing and his close personal relationship with JDC, he was able to acquire a five-year contract (his fifth consecutive 5-year contract with JDC) that not only tripled sales, but did so at a price that was fair to both CC and JDC. CC was a single product company producing high quality cast iron gizmos for JDC’s Dubuque Plant, which is located across the street from CC’s production facility. Gizmos, although large, very heavy and bulky, are a critical element in JDC’s automatic transmissions. CC was providing the JDC Dubuque Plant with almost one-half of its need for gizmos on the condition that CC participates in JDC’s just-in-time inventory system.

In February 2007, Jacob Carter, confident that he had achieved his dream of providing a good income for his family, retired and turned the business over to his son, Robert. Robert had graduated from Harvard University in June 2006 and had worked in marketing since graduation. Robert had also worked a couple of summers on the production line in the CC manufacturing plant while attending high school. Although ownership of CC was shared equally among the family (father, mother, son, and three sisters), only Robert worked in the company. Robert’s three sisters were in school; Janis was a sophomore at Harvard University, Beverly was in her first year at Princeton Law School, and Alice was in her second year at Berkeley Medical School.

In January 2008, Robert Carter was reviewing his ten months as president and was thinking about the future. In the summer of 2007, Robert had replaced his father’s plant manager of 20 years with a close friend and fraternity brother. Although the employees respected the old plant manager, Robert felt that a more humanistic and participative management style was needed. The loyal, long-term employees of CC were dissatisfied with the new plant manager’s change from an assembly line operation to a job enrichment program and went out on strike—the first strike in CC’s history. The just-in-time inventory requirement by JDC necessitated that CC settle the labor dispute quickly to avoid the possibility of losing the contract. To complicate matters even more, the purchasing manager quit and Robert has rotated two purchasing managers through the position with no success. JDC has recently notified CC that, although it had been pleased with CC’s performance in the past, some recent problems with product quality and delivery concern top level JDC management. Robert believed he had learned a great deal about business during the past ten months and was now ready to put his personal stamp on CC.

Many of Robert’s classmates at Harvard had taken jobs in international business. At the December 2007 class reunion, Robert found that manufacturing gizmos in Dubuque, Iowa was hard to make glamorous to his classmates. Robert was thinking of pursuing a new strategy of moving CC’s production facilities to a more exciting location, but keeping its sales office in Dubuque. Since Robert had majored in African history at Harvard and he wanted to continue his exploration of that area, he was considering Uganda as a possible location for CC.

Uganda is a landlocked, agrarian based country surrounded by Zaire, Sudan, Kenya, and Tanzania. Since gaining independence from Great Britain in 1962, Uganda has been through a violent transformation. Military governments have overthrown military governments. Hundreds of thousands of people have been murdered by dictators. Foreign property has been nationalized and foreigners expelled. Poverty and illiteracy is rampant. Uganda presently has among the highest levels of AIDS in the world. Although Uganda currently still has serious political and economic problems, Robert believes that, with his knowledge of Africa, he could open a manufacturing facility that could help bring peace and economic success to that war-torn country. He was anxious to prove his undergraduate thesis that postulated continuing civil strife in African nations was caused solely by poverty, which could be eliminated with large injections of foreign capital. By moving its production facilities to Uganda, CC could reduce its labor costs by 75%, help an underdeveloped country, and also teach CC’s ungrateful employees something about respect for management authority.

Carter Company

Financial Statements

Balance Sheet

(in $1,000)

Dec. 31,2006 Dec. 31, 2007

Assets

Cash 2,000 1,000

Accounts Receivable 750 2,000

Inventories 250 3,000

Fixed Assets 3,000 12,000

Total Assets 6,000 18,000

Liabilities & Equity

Accounts Payable 500 4,000

Short-term Notes Payable 500 2,000

Long-term Debt 1,000 6,000

Capital Stock 1,000 1,000

Retained Earnings 3,000 5,000

Total Liabilities & Equity 6,000 18,000

Income Statement

(in $1,000)

FY 2006 FY 2007

Sales 12,000 36,000

Labor 3,000 15,000

Materials 1,400 8,000

Factory Overhead 1,000 3,000

Marketing 3,000 5,000

General Administrative 1,200 3,800

Profit Before Taxes 2,400 1,200

Taxes 960 480

Profit 1,440 720

Questions:

1. How would you assess Carter Company’s present liquidity situation? How has it changed since 2006? What are the implications?

2. Assess Carter Company’s present leverage situation? How has it changed since 2006? What are the implications?

3. How would you assess Carter Company’s present fixed asset utilization, inventory turnover and collections. How have they changed since 2006? What are the implications?

4. What do you see as the major issue facing Robert now?

5. What are the major reasons for Carter Company’s decrease in net profits to net sales over the past year?

6. Has Robert Carter’s vision of Carter Company changed from that of his father’s?

Roger McDaniels sat in front of his computer pondering hisimmediate future. He had just finished an impromptu meeting withBeth Sullivan from the internal audit department and his confidencewas shaken. Both Roger and Beth left the meeting wondering if theirrecent decisions were for the best.
Roger's accounting career began approximately ten years ago when hebecame a CPA. Over the last decade, Roger had been successfullyemployed in a variety of accounting positions. It therefore came asno surprise to Roger when three months ago, he was contacted by anexecutive recruiter and offered the CFO position at SolodorPharmaceuticals (SP). SP's mission was to conduct tests on Celenza,a new drug that had been developed to fight acute lymphoblasticleukemia. If successful, Celenza had the potential to increase theaverage life expectancy of affected patients by up to six years.Celenza offered terminal patients the most hope of any drug in overa decade. Although not stated publically, it was known in theindustry that other pharmaceutical companies did not want to incurthe significant costs associated with developing a similar drugbecause sales of a new drug would merely cannibalize sales fromtheir current, but less effective medications.
Upon accepting the employment offer from SP, Roger felt veryexhilarated. If SP's mission was successful, not only would Rogerbe handsomely rewarded (as his compensation package provided himwith numerous stock options, which in themselves would likely makeRoger a millionaire), but Roger would also play a part in extendingthe lives of numerous terminally ill patients. Given the history ofdeath in his family from various forms of cancer, more specificallythe death of his father from leukemia when he was only a child,Roger was all too aware of the pain and mental anguish associatedwith terminal illnesses.
Upon starting his new position, Roger was not surprised to learnthat, similar to other new pharmaceutical companies, SP wascurrently experiencing severe cash flow problems. Thus, theimmediate priority for Roger was to procure a round of additionalequity financing. If Celenza was shown to be successful, it had thepotential to be a cash cow. However, in its current state, SP hadno expectations of any Celenza sales occurring for at least twomore years because extensive testing was needed before the FDA'sCenter for Drug Evaluation and Research would even considerapproving the drug. Without obtaining a minimum of $5,500,000, SPwould run out of money and be forced to liquidate within the nextfour months. This would not only leave Roger unemployed but wouldmake his stock options worthless. It would also put Celenza'sfuture in jeopardy.
Roger recently held meetings with three different financiers andpessimistically awaited their responses. Due to the weak economy,raising significant equity financing was an extremely difficulttask. Therefore, when Steve Butler called to arrange a breakfastmeeting, Roger was anxious.
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Steve Butler was a senior vice-president of Cambridge, a venturecapital firm with access to over a billion dollars. If SP'smanagement team impressed Steve, Roger knew the firm's currentfinancial woes would be solved. However, if SP's management teamfailed to impress...well, Roger chose not to concentrate on thatoption.
The breakfast meeting between Roger and Steve came and went withSteve appearing to be extremely intrigued with the market potentialof Celenza. At the end of breakfast, Steve suggested that Cambridgewould potentially be willing to invest up to $5,500,000 but onlyafter conducting a thorough analysis of Celenza's researchprogress.
Accordingly, two weeks after the breakfast meeting, scientists fromCambridge spent ten days examining the research that SP hadconducted to date on Celenza. Roger was feeling cautiouslyoptimistic because Steve's team seemed to be impressed. However, asweeks went by Roger's pessimism began to return. It had been threeweeks since the team had visited SP and Roger had yet to hear fromSteve.
Two days later the phone rang in Roger's office. After realizing itwas Steve calling, Roger attempted not to act apprehensive. Duringthe call, Steve explained that his firm was in the process ofpreparing a share purchase agreement in which Cambridge wouldpurchase up to 55 percent of SP. Cambridge was willing to pay$100,000 for each 1 percent of SP ownership, conditional onobtaining a controlling interest in SP. After hanging up, Rogerexhaled deeply and exhaustively leaned back in his chair as heconsidered Cambridge's proposal. On the positive side, the news ofan equity purchase could not have come at a better time since SP'screditors were phoning daily requesting payment. On the negativeside, obtaining the required $5,500,000 meant Cambridge wouldeffectively control SP. Cambridge had a reputation for replacingthe management teams in firms that it acquired and for pursuing ahigh-price/low-volume marketing strategy. The possibility of beingfired would be catastrophic for Roger since he had to be employedby SP for at least one year before his stock options would fullyvest. Cambridge's marketing strategy would also be in contrast tothe desires of SP's current management team who wanted to maximizeprofits—but also planned on being socially responsible byimplementing a low price/high volume marketing strategy. Rogerclenched his jaw in agony because he knew that ahigh-price/low-volume strategy meant that Celenza would only beavailable to the wealthy and not available to those who werecovered by traditional health insurance policies.
After waiting a sleepless week during which no draft agreementappeared, Roger became increasingly agitated. Roger did not want toact hastily but after he could wait no longer he phoned Steve'soffice. Although Steve was out of the office, Roger reached Steve'sassistant and asked to see a draft of the purchase agreement. Theassistant agreed to overnight a hard copy of the deal.
Upon returning from lunch the next day, Roger noticed a UPS packageresting on the corner of his desk. As he tore open the documentRoger's heart palpitated with nervous excitement. As he glancedover the first sheets he immediately noticed that this wasnot
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a draft of the agreement between Cambridge and SP but a final copyof a deal between Cambridge and Dugas Incorporated that was to beannounced the next day.
Roger's first instinct was to throw away the draft without readingit because it was obvious to Roger that Steve's assistant had madea mistake and sent him a copy of the wrong deal. However, curiositygot the best of Roger so he decided to read over the entiredocument. Afterward, Roger checked the Internet for details ofDugas Incorporated. There did not seem to be any public informationavailable about a deal between Cambridge and Dugas Incorporated.Now consumed with interest, Roger noticed that Dugas Incorporatedwas currently trading on the New York Stock Exchange at $3.14 pershare, down from a yearly high of $28.45. He next reviewed a fewfinancial news articles that expressed concern regarding DugasIncorporated's cash flow. The articles also expressed doubt thatDugas Incorporated would be able to obtain the additional financingit needed to stay afloat.
Roger reclined in his chair realizing that he was privy to a verysignificant piece of information. In less than 24 hours DugasIncorporated would announce Cambridge's investment. This news wassure to have a significant impact on the price of DugasIncorporated's stock. Roger contemplated just how high their stockprice would go, maybe $10, maybe $15, maybe even past its yearlyhigh.
Roger could not believe his good fortune. A grin slowly creptacross Roger's mouth as he accessed SP's operating account and usedevery last dollar to purchase 470,000 shares in Dugas Incorporated.Roger was actually giddy with excitement and found that he couldbarely contain himself. With the profits that SP would make oncethe news regarding Dugas Incorporated went public, he had singlehandedly prevented SP from surrendering control to Cambridge. Hehad never felt better about himself. Roger was now fully confidentthat he would remain at SP long enough for his options to vest. AsRoger left his office that day he realized that his actions wouldstop Cambridge from imposing a high-price/low-volume marketingstrategy on SP such that only the very wealthy could affordCelenza. Roger found it satisfying to help people who sodesperately needed it.
A month later, Roger's actions were discovered by Beth Sullivan, aninternal auditor at SP, while performing a routine test on astratified sample of cash transactions. Beth discovered that Rogerused SP's operating funds to purchase shares in Dugas Incorporatedjust one day before the stock price skyrocketed. This discovery ledBeth, who was unsure if she should further investigate thetransaction, to request an impromptu meeting with Roger. Beth choseto discuss the situation with Roger rather than her immediatesuperior because SP's corporate structure was such that the head ofthe internal audit department ultimately reported to Roger, theCFO.
The meeting had only begun when Roger somewhat aggressivelyinstructed her to simply drop the transaction from her sample. Tounderscore his point he made sure to mention that he was her boss'sboss, and ultimately the person in charge of the internal auditdepartment. Sensing that Beth was uncomfortable with hisinstructions, Roger
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slumped forward exhaustively and elaborated on his heartfeltreasons for having used corporate funds to purchase the shares inDugas Incorporated. After her meeting with Roger, Beth experiencedan uneasy feeling in the pit of her stomach.
It was now two months since Beth's meeting with Roger but Bethstill felt queasy when she contemplated Roger's actions. She hadlain in bed the previous night tossing and turning unable to sleep.As she showered that morning she considered that it was importantto ensure that she acted legally in spite of ethicality. Peoplewere thrown in jail for violating the law not for violating ethics.She resolved that in spite of thinking that perhaps Roger hadbehaved ethically, she had to behave rationally. If she reportedRoger's actions, there was no way by which she could be heldlegally responsible for any of Roger's actions. There was also nomeans by which Roger or SP could fire her, for the Sarbanes-OxleyAct of 2002 (SOX, U.S. House of Representatives 2002) provided herwith protection from their retribution. She never realized thatreading the Occupational Safety and Health Administration (OSHA)fact sheet in SP's lunchroom would help her resolve such asignificant dilemma. After many bored lunch breaks she could nowrecall the fact sheet verbatim:
An employer covered under SOX may not discharge or in any mannerretaliate against an employee because he or she: providedinformation, caused information to be provided, or assisted in aninvestigation by a federal regulatory or law enforcement agency, amember or committee of Congress, or an internal investigation bythe company relating to alleged mail fraud, wire fraud, bank fraud,securities fraud, violation(s) of SEC rules and regulations, orviolation(s) of federal law relating to fraud against shareholders.(OSHA 2011)
As Beth arrived at work that morning, after a brief stop at thelocal coffee shop, she confidently wrote a letter to SP's Board ofDirectors informing them of Roger's actions.
Answer the following Questions:

1. Identify and briefly discuss the key issue(s) in the case.
2. What was the ethical dilemma faced by Beth Sullivan?
3. Do you think Beth acted ethically? Why or why not?
4. Are there any other alternative courses of action possible forBeth?