CMS Business School MBA 2023-25

Course: Finance For Managers (FFM) Code: 23MBADSE211

Semester-2 BLOCK – 1

Continuous Internal Assessment (CIA)

Topic of the Assignment:

“Case Study: Taylor Brands Cost of Capital”
Group
Sl. No. Name (in Caps only) USN Signature
No.

1 DEEPTHI M 23MBAR0380 03 DEEPTHI M

2 HIRAN KUMAR R 23MBAR0334 03 HIRAN KUMAR R

3 B SURYA 23MBAR0377 03 B SURYA

M SUHAAS
4 M SUHAAS 23MBAR0342 03

J BRISKILLA
5 J BRISKILLA 23MBAR0384 03

RANYA
6 23MBAR0387 03 RANYA MANORANJIT
MANORANJIT
Date of Submission: 28-JAN-2024
Submitted to Prof. (name in Caps): Dr. SUDINDRA V R
Abstract:
This case study revolves around Taylor Brands, a company that currently uses a 30
percent discount rate for project evaluation. The high discount rate leads to the rejection
of potentially valuable projects and encourages overly optimistic cash flow projections.
Robert West, an innovative executive, is tasked with determining Taylor's cost of
capital. He is determined to conduct a thorough evaluation to convince the general
manager, Trevor Unruh, of the importance of obtaining an accurate cost of capital. West
considers the company's EPS growth, dividend per share, and industry risk in order to
make decisions regarding implementing a 70% payout ratio and an average return of
12% on retained earnings. He also estimates Taylor's beta to be around 1.2, which is
adjusted downward due to the company's decreasing degree of operating leverage. The
case provides financial information and challenges faced by West in estimating the
required return on equity and the company's cost of capital.

Case Summary:

Taylor Brands currently uses a 30 percent discount rate for project evaluation, leading to
the rejection of potentially valuable projects and encouraging overly optimistic cash
flow projections. Robert West, an innovative executive, is assigned the task of
determining the company's cost of capital. Despite initial skepticism from the general
manager, Trevor Unruh, West is determined to conduct a thorough evaluation to
convince Unruh of the importance of obtaining an accurate cost of capital. The case
provides financial information and outlines the challenges faced by West in estimating
the required return on equity and the company's cost of capital.

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.

Ans:

Yes, West's intention to adjust Taylor's beta estimates downward due to the decreasing
degree of operating leverage seems appropriate. Beta measures a stock's sensitivity to
market movements, and a lower degree of operating leverage generally suggests reduced
business risk. Operating leverage measures the fixed versus variable costs in a company's
operations. As Taylor is altering production techniques to reduce operating leverage, it
indicates a potential decrease in the company's vulnerability to market fluctuations.
Lower operating leverage typically results in lower beta, as the firm is less sensitive to
changes in the overall market. Therefore, adjusting beta downward is a reasonable step
to better reflect the changing risk profile of Taylor and provide a more accurate
assessment of its exposure to market movements.
 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.

(b) Use the dividend valuation model to estimate Ke.
(c) In your view, what is? Justify your choice.

Ans:

(a) The risk-free (long-term government bond) rate is 7% as shown in Exhibit 4, and
the risk- premium on the average risk stock is 7.2% based on the information in
Exhibit 2. Beta estimates are 0.8 to 1.2, but appear a bit high, thus the lower limit
of this range will be used.
(b) Ke= (D1/PO) + g
P0= (28+36)/2 = $32
D1 = $2.05
g= .3*.12=.036
Ke= (2.05/$32) + .036 = 0.1001 10.01%
(c) Ke or Cost of equity is the return the firm pays to its equity investors. This
payment is to compensate investors/shareholders for the risk they take on and is usually
represented as a percentage. So, 12.76% based on CAPM

3. Estimate Taylor's cost of capital or required rate of return. (You may use book
values in your calculations. Assume the existing capital structure is optimal and
ignore preferred stock. The relevant tax rate is 40 percent.)

Ans:
Required Return Debt = 07 (1-4) = 4.2%
Required Return Bond = .08 (1-4) = 4.8%
Required Return Equity = 12.76%

Notes payable 16,000 7%

Bonds 89,000 38%
Equity 130,000 55%

WACC = 07(042) + 38(048) + 55(.1276)

WACC = 9.14%
 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?

Ans:
Assuming investors are rational, it is due to the preferential tax treatment the dividends
receive. Most preferred stock is purchased by the companies and the dividends they
receive are large tax exemptions. Thus, many companies view the purchase of preferred
stock as the way investors view tax exemption for municipal bonds. The relevant one is
the after-tax return received by the investors from preferred stocks and bonds. If the
yield on these investments were adjusted for taxes, the after-tax return on preferred
stocks would be higher.

5.
(a) Estimate the cost of preferred stock (required return of preferred stock).
(b) Redo question 3 including preferred stock as a financing source, and assume the
target weights are as follows: notes,5 percent; bonds, 40 percent; preferred, 5 percent;
equity, 50 percent.

Ans:

(a) These companies are less risky compared to Taylor. Since there are yield differences
on the preferred stock of firms in roughly the same industry which is 75 to 100 basis
points, thus adjust by 80 basis points, meaning to 8%. The 8% is calculated from the
average of the industry, (9.14+7.14) %/2= 8.14% (rounded off to become 8%).

(b) Redo question 3 including preferred stock as a financing source, and assume the
target weights are as follows: notes, 5 percent; bonds, 40 percent; preferred, 5 percent;
equity, 50 percent.
WACC= 0.05(4.20%) + 0.40(4.80%) + 0.05(8%) + 0.5(12.76%)
= 8.91%

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?
Ans:
The information about flotation costs is what we would like to make more informed
estimates about the cost of equity and the cost of preferred stock. The Rate of return for
the cost of equity and the cost of preferred stock are also important for us to make more
informed estimates. Moreover, information about Taylor's EPS growth and current
market price is also required to make more informed estimates about the cost of equity
and the cost of preferred stock. In addition, information about beta estimates based on
Taylor's current degree of operating leverage is needed to obtain a more accurate risk
premium.

7. What would you guess is the market value of the firm's notes payable? Explain.

Ans:
We would say that the market value of the firm's notes payable is reasonable since it's
somewhere near its book value. It is because those securities like preferred stock,
common stock, and so on happen to mature in the short term. Those securities are riskier
and are easily influenced by the changes in interest rates compared to the market value.