The Oceanic Corporation (Determining the Cost of Capital)

872 WordsApr 29, 20134 Pages
The Oceanic Corporation (Determining the Cost of Capital) Larry Stone wants to estimate the firm’s hurdle rate because it is a benchmark for how well the company needs to do on a project in order to at least break even. The higher the hurdle rate, the riskier the project will have to be and the lower the hurdle rate is, the safer the project will be for a company. A company should strive for a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate or better, then the cash should be given as dividends to the stockholders. As long as the risk is roughly the same for all divisions and there are no outliers, then it doesn’t matter if Larry…show more content…
However, there is no indication that the company is planning on doing so currently, so we can ignore the flotation costs. The flotation cost equals the cost of issuing new stock plus the cost of retained earnings. According to Stephanie’s assumptions, the companies flotation cost is 5% of the issue price of debt. The firm’s hurdle rate can be calculated as the Weighted Average Cost of Capital (WACC) as demonstrated on worksheet Calculations. (1-Tc)rd(D/V)+re(E/V) Where: * Tc is the corporate tax rate (34% per Stephanie’s assumptions) * rd is the cost of debt (estimated as the YTM) * re is the cost of equity ((rf + β(rm – rf)); (.04 + 1.5 (.10-.04))=.13)) [rf is the risk free rate defined as the treasury bill rate and rm is the market rate of return] * D is dividend (40) * E is equity (60) * V is total value of dividends and equity (100) The company’s hurdle rate equals: ((1-.34)(.1084)(40/100)) + ((.13)(60/100)) x 100 = 10.66% If the company doesn’t take on any high risk projects or new divisions, the hurdle rate may remain constant or very close to the calculated number. The hurdle rate of 10.66% is a safe hurdle rate that will guide the company in making good
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