The Oceanic Corporation, a Chesapeake, VA based company, was established in 1994. Glenn Rodgers III founded the corporation, which was privately owned at the time, after his retirement from Norentech Corporation.

            The Oceanic Corporation was originally formed to provide ship repair services and quickly earned a Department of Defense (DOD) certified Alteration Boat Repair (ABR) designation. Among its specialties were structural welding, piping system installation and repairs, custom sheet metal fabrication. Other divisions of The Oceanic included Habitability Installation, Industrial Contracting, and Alteration/Installation Teams (AIT). With its initial success and good return on investment the firm opened and operated facilities in California, New Jersey, Florida, Maryland, Pennsylvania and Washington.

            In 1998, the company went public and its initial public offering was very successful. The stock price had risen from its initial value of $10 to its current level of $35 per share. There were currently 5 million shares outstanding. In 1999, the company issued 30-year bonds at par with a face value of $1000 and a coupon rate of 10% per year, and managed to raise $40 million for expansion. Currently, the AA rated bonds had 25 years left until maturity and were being quoted at 91.15% of par.

            Over the past year, The Oceanic Corporation utilized a new method for fabricating composite materials that the firm’s engineers had developed. In June of last year, management established the Advanced Materials Group (AM Group), which was dedicated to pursuing this technology. The firm recruited Larry Stone, a senior engineer, to head the AM Group. Larry also had an MBA from a prestigious university under his belt.

            Upon joining Oceanic, Larry realized that most projects were being approved on a “gut feel” approach. There were no formal acceptance criteria in place. Up until then, the company had been lucky in that most of its projects had been well selected and it had benefited from good relationships with clients and suppliers. “This has to change,” said Larry to his assistant Stephanie, “we can’t possibly be this lucky forever. We need to calculate the firm’s hurdle rate and use it in future.” Stephanie Phillips, who had great admiration for her boss, replied, “Yes, Larry, why don’t I crunch out the numbers and give them to you within the next couple of days?” “That sounds great, Stephanie,” said Larry. “My years of experience tell me that when it comes to the hurdle rate for new projects, one size hardly ever fits all!”

            As Stephanie began looking at the financial statements, she realized that she was going to have to make some assumptions. First, she assumed that new debt would cost about the same as the yield on outstanding debt and would have the same rating. Second, she assumed that the firm would continue raising capital for future projects by using the same target proportions as determined by the book values of debt and equity (see Table 1 for recent balance sheet). Third, she assumed that the equity beta (1.5) would be the same for all the divisions. Fourth, she assumed that the growth rates of earnings and dividends would continue at their historical rate (see Table 2 for earnings and dividend history). Fifth, she assumed that the corporate tax rate would be 34%, and finally, she assumed that the flotation cost for debt would be 5% of the issue price and that for equity would be 10% of selling price. The 1-year treasury bill yield was 4% and the expected rate of return on the market portfolio was 10%

ASSIGNMENT: CALCULATE THE FIRM'S COST OF DEBT
Transcribed Image Text:The Oceanic Corporation Balance Sheet ('000s) 5,000 Accounts Payable 10,000 Accruals 20,000 Notes Payable 35,000 Total Current Liabilities Cash 8,000 Accounts Receivable 5,000 10,000 23,000 Inventory Total Current Assets 43,000 Long-term debt 45,000 Common stock (5 million shares outstanding) 88,000 Retained Earnings Land & Buildings (net) 40,000 Plant and Equipment (net) 50,000 Total Fixed Assets 10,000 100,000 Total Assets 123,000 | Total liabilities and Shareholder's Equity 123,000 Table 2 The Oceanic Corporation Sales, Earnings, and Dividend History ('000s) Year Sales Earnings per Share Dividends per Share 1998 24,000,000 0.48 0.10 1999 28,800,000 0.58 0.12 2000 36,000,000 0.72 0.15 2001 45,000,000 0.86 0.18 2002 51,750,000 0.96 0.20 2003 62,100,000 1.06 0.22 2004 74,520,000 1.20 0.25

Question

The Oceanic Corporation, a Chesapeake, VA based company, was established in 1994. Glenn Rodgers III founded the corporation, which was privately owned at the time, after his retirement from Norentech Corporation.

The Oceanic Corporation was originally formed to provide ship repair services and quickly earned a Department of Defense (DOD) certified Alteration Boat Repair (ABR) designation. Among its specialties were structural welding, piping system installation and repairs, custom sheet metal fabrication. Other divisions of The Oceanic included Habitability Installation, Industrial Contracting, and Alteration/Installation Teams (AIT). With its initial success and good return on investment the firm opened and operated facilities in California, New Jersey, Florida, Maryland, Pennsylvania and Washington.

In 1998, the company went public and its initial public offering was very successful. The stock price had risen from its initial value of $10 to its current level of $35 per share. There were currently 5 million shares outstanding. In 1999, the company issued 30-year bonds at par with a face value of $1000 and a coupon rate of 10% per year, and managed to raise $40 million for expansion. Currently, the AA rated bonds had 25 years left until maturity and were being quoted at 91.15% of par.

Over the past year, The Oceanic Corporation utilized a new method for fabricating composite materials that the firm’s engineers had developed. In June of last year, management established the Advanced Materials Group (AM Group), which was dedicated to pursuing this technology. The firm recruited Larry Stone, a senior engineer, to head the AM Group. Larry also had an MBA from a prestigious university under his belt.

Upon joining Oceanic, Larry realized that most projects were being approved on a “gut feel” approach. There were no formal acceptance criteria in place. Up until then, the company had been lucky in that most of its projects had been well selected and it had benefited from good relationships with clients and suppliers. “This has to change,” said Larry to his assistant Stephanie, “we can’t possibly be this lucky forever. We need to calculate the firm’s hurdle rate and use it in future.” Stephanie Phillips, who had great admiration for her boss, replied, “Yes, Larry, why don’t I crunch out the numbers and give them to you within the next couple of days?” “That sounds great, Stephanie,” said Larry. “My years of experience tell me that when it comes to the hurdle rate for new projects, one size hardly ever fits all!”

As Stephanie began looking at the financial statements, she realized that she was going to have to make some assumptions. First, she assumed that new debt would cost about the same as the yield on outstanding debt and would have the same rating. Second, she assumed that the firm would continue raising capital for future projects by using the same target proportions as determined by the book values of debt and equity (see Table 1 for recent balance sheet). Third, she assumed that the equity beta (1.5) would be the same for all the divisions. Fourth, she assumed that the growth rates of earnings and dividends would continue at their historical rate (see Table 2 for earnings and dividend history). Fifth, she assumed that the corporate tax rate would be 34%, and finally, she assumed that the flotation cost for debt would be 5% of the issue price and that for equity would be 10% of selling price. The 1-year treasury bill yield was 4% and the expected rate of return on the market portfolio was 10%

ASSIGNMENT: CALCULATE THE FIRM'S COST OF DEBT

The Oceanic Corporation
Balance Sheet
('000s)
5,000 Accounts Payable
10,000 Accruals
20,000 Notes Payable
35,000 Total Current Liabilities
Cash
8,000
Accounts Receivable
5,000
10,000
23,000
Inventory
Total Current Assets
43,000 Long-term debt
45,000 Common stock (5 million shares outstanding)
88,000 Retained Earnings
Land & Buildings (net)
40,000
Plant and Equipment (net)
50,000
Total Fixed Assets
10,000
100,000
Total Assets
123,000 | Total liabilities and Shareholder's Equity
123,000
Table 2
The Oceanic Corporation
Sales, Earnings, and Dividend History
('000s)
Year
Sales
Earnings per Share
Dividends per Share
1998
24,000,000
0.48
0.10
1999
28,800,000
0.58
0.12
2000
36,000,000
0.72
0.15
2001
45,000,000
0.86
0.18
2002
51,750,000
0.96
0.20
2003
62,100,000
1.06
0.22
2004
74,520,000
1.20
0.25

Accepted Answer

YTM is that single rate which makes the worth of future cash flows and coupon amount equal to its…