SEA SHORE SALT COMPANY ANALYSIS OF WEIGHTED AVERAGE COST OF CAPITAL BERNICE STARTED WORKING ON JANUARY 2, 2009

Analysis of weighted average cost of capital

Bernice started working on January 2, 2009. the first 2 weeks went smoothly. then Mr. brinepool\'s cost of capital memo (see figure 13-2) 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 13-6 below. 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 and dividends per share probably $2. sea shore salt had traditionally paid out 50% of earnings as dividends and plowed back the rest.
earnings and dividends had grown steadily at 6% to 7% per year, in line with the company\'s sustainable growth rate: sustainable rate growth rate=return on equity x plowback ratio =4/30 x .5 =.067, or 6.7%.
sea shore salt\'s beta had averaged about .5, which made sense, Bernicethought, for a stable, steady-growth business. she made a quick cost of equity calculationby using the capital asset pricing model (CAPM). with current interest rates of about 7% and a market risk premium of 7%: CAPM cost of equity==7%+.5(7%) =10.5%.
this cost of equity was significantly less than the 16% decreed in Mr. binepool\'s memo. Bernice scanned her notesapprehensively. what if Mr. brinepool\'s cost of equity was wrong? was there some other way toestimate the cost of equity as a check on the CAPM calculation? could there be other errors in hiscalculation? Bernice resolved to complete her analysis that night. if necessary, she would try to speakwith Mr. brinepool when he arrived at his office the next morning. her job was not just finding theright number. she also had to figure out how to explain it all to Mr. brinepool.


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