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Mini Case (Capital Structure)

Bernice Mountaindog had recently been promoted to treasury analyst at Sea Shore Salt after completing her degree in finance. She was tasked with explaining the company's weighted-average cost of capital to other managers. In preparing for questions, Bernice examined the company's balance sheet and noted details about the preferred stock, common stock, earnings growth, and beta. Using the capital asset pricing model, she calculated Sea Shore Salt's cost of equity to be 11%, significantly less than the 16% figure provided in her boss's memo. Bernice resolved to complete her analysis and speak to her boss if needed to explain her different calculation and ensure there were no errors.

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436 views

Mini Case (Capital Structure)

Bernice Mountaindog had recently been promoted to treasury analyst at Sea Shore Salt after completing her degree in finance. She was tasked with explaining the company's weighted-average cost of capital to other managers. In preparing for questions, Bernice examined the company's balance sheet and noted details about the preferred stock, common stock, earnings growth, and beta. Using the capital asset pricing model, she calculated Sea Shore Salt's cost of equity to be 11%, significantly less than the 16% figure provided in her boss's memo. Bernice resolved to complete her analysis and speak to her boss if needed to explain her different calculation and ensure there were no errors.

Uploaded by

pals
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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MINI CASE : CAPITAL STRUCTURE

Bernice Mountaindog was glad to be back at Sea Shore Salt. Employees were treated well. When she
had asked a year ago for a leave of absence to complete her degree in finance, top management
promptly agreed. When she returned with an honors degree, she was promoted from administrative
assistant (she had been secretary to Joe-Bob Brinepool, the president) to treasury analyst.

Bernice thought the company’s prospects were good. Sure, table salt was a mature business, but Sea
Shore Salt had grown
steadily at the expense of its less well-known competitors. The company’s brand name was an
important advantage, despite the difficulty most customers had in pronouncing it rapidly.

Bernice started work on January 2, 2000. The first two weeks went smoothly. Then Mr. Brinepool’s
cost of capital memo assigned her to explain Sea Shore Salt’s weighted-average cost of capital to other
managers. The memo came as a surprise to Bernice, so she stayed late to prepare for the questions that
would surely come the next day.

Bernice first examined Sea Shore Salt’s most recent balance sheet, summarized in Table 4.14. Then she
jotted down the following additional points:

 The company’s bank charged interest at current market rates, and the long-term debt had just been
issued. Book and market values could not differ by much.
 But the preferred stock had been issued 35 years ago, when interest rates were much lower. The
preferred stock was now trading for only $70 per share.
 The common stock traded for $40 per share. Next year’s earnings per share would be about $4.00
and dividends per share probably $2.00. Sea Shore Salt had traditionally paid out 50 percent of
earnings as dividends and plowed back the rest.
 Earnings and dividends had grown steadily at 6 to 7 percent per year, in line with the company’s
sustainable growth rate:

 Sea Shore Salt’s beta had averaged about .5, which made sense, Bernice thought, for a stable,
steady-growth business. She made a quick cost of equity calculation using the capital asset pricing
model (CAPM). With current interest rates of about 7 percent, and a market risk premium of 8
percent,

CAPM cost of equity = rE = rf + (rm – rf)


= 7% + .5(8%) = 11%
This cost of equity was significantly less than the 16 percent decreed in Mr. Brinepool’s memo. Bernice
scanned her notes apprehensively. What if Mr. Brinepool’s cost of equity was wrong? Was there some
other way to estimate the cost of equity as a check on the CAPM calculation? Could there be other
errors in his calculations?

Bernice resolved to complete her analysis that night. If necessary, she would try to speak with Mr.
Brinepool when he arrived at his office the next morning. Her job was not just finding the right number.
She also had to figure out how to explain it all to Mr. Brinepool.

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