Financial Management Report

Case-13: Taylor Brands: Cost of capital or required rate of return

Group-5: Urja, Kovidha, Prachi & Shailja

CASE OVERVIEW
The management of Taylor Brands takes caution while establishing a high 30%
discount rate for project assessments, which many executives believe is too high.
Investment in potentially beneficial initiatives with returns that are near but
somewhat below this level is discouraged by this rate. Some managers exaggerate
cash flow estimates in order to get project clearance. Additionally, the pace seems
random, giving the impression that it was chosen without careful consideration.

One of Taylor's creative executives, Robert West, has attended seminars on cost-of-
capital estimation and demonstrated an interest in finance. According to him,
figuring out an exact cost of capital might enhance project selection and get rid of
the idea that it's random. West is driven to provide a comprehensive report even if
his task to determine the cost of capital appears trivial.

Based on anticipated market circumstances, West has calculated future payment and
return rates and collected financial data, such as bank note and bond yield statistics.
Additionally, he took into account how anticipated adjustments to operational
leverage may reduce Taylor's risk profile. Despite the fact that Taylor's capital
structure does not include preferred stock, West projected how Taylor's prospective
preferred stock may compare using information from other companies.

Using this data, West hopes to create an engaging report that tackles Taylor's
discount rate problems and offers a thorough cost of capital analysis.

OBJECTIVE OF TE CASE
The primary objective of this case appears to be to establish an accurate and realistic
cost of capital for Taylor Brands to enhance decision-making and align financial
strategy with company goals and shareholder expectations. Specifically, the objectives
include:
  Determine an Appropriate Discount Rate: The case highlights the need to
replace the arbitrarily high 30% discount rate with one that reflects Taylor’s
actual cost of capital, which should be based on a careful assessment of the
company's risk, industry benchmarks, and capital structure.

 Improve Project Evaluation: By adopting a realistic discount rate, Taylor Brands

aims to ensure that valuable projects are not prematurely rejected due to an
overly high hurdle rate. This will help in selecting projects that genuinely add
value to the firm rather than filtering them out based on inflated financial
thresholds.

 Adapt to Changes in Capital Structure and Operating Leverage: As Taylor plans

to issue preferred stock and alter its production techniques to reduce operating
leverage, the cost of capital should be accurately recalibrated to reflect these
changes, ensuring that financial metrics evolve with company adjustments.

In summary, the case’s objective is to guide Taylor Brands toward establishing a more
accurate cost of capital to support sound financial decision-making, improve project
selection, and ensure alignment with shareholder interests, thereby creating a stronger
foundation for sustainable growth.

Question -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.
Solution: Some downward adjustment seems appropriate. The DOL affects the market or
systematic risk of the firm and beta is, of course, a measure of such risk. Thus if the DOL
decreases, then so does the firm's market risk, and consequently, its beta. Stated differently,
the -8-1.2 beta range is apparently based on information obtained when Taylor's market risk
was higher than it is now.
Though some downward adjustment seems appropriate, it is another question how much the
beta estimate should be decreased.
Question 2:
The required return on equity (cost of equity), K„ can be estimated in a number of ways.
(a) Estimate K, using a risk premium approach.
(b) Use the dividend valuation model to estimate K
(c) In your view, what is K? Justify your choice

Solution:
(a.) The CAPT can be used as follows:
K. = B (K. - K,)
where K, is the risk-free rate and K. - K, is the risk premium investors require to purchase the
stock of a company with average market risk.
The risk-free (long-term government bond) rate is 78 (Exhibit Four), and the risk-premium on
the average risk stock is 7.2% based on the information in Exhibit Two.
Beta estimates are .8 to 1.2, but appear a bit high (see Question 1) and we will, therefore, use
the lower limit of this range.
K = 0.07 + 0.8 (- 072) - - 1276

(b.)
The dividend valuation model (DVM) is another technique for estimating K.
Assuming continuous growth, a K.
estimate is based on
K. = D1/Pm + g
where D1 is the expected dividend in one year, Pm is the current market price, and g is the
expected growth in future dividends. We will estimate Pm using the average of the high and
low price shown in Exhibit Four:
Pm = (36 + 28) /2 = $32.
Based on information in the case, DPS growth will increase and should become more in line
with EPS growth. But past EPS growth has been quite high and is not expected to continue
(the arithmetic average of the annual EPS increases in Exhibit Three is 32% and the geometric
mean is 31%). We can, however, use the Gordon model to obtain an estimate of g using
b*R=g, where b is the proportion of earnings retained and R is the return on retained earnings.
Using West's estimates of .3 (one minus the estimated payout ratio of .7) and 12% we obtain
g = .3 * .12 = .036
Our DVM K, estimate is
K = .7 x 2.83(1.036) + .036
K = 2.05/32 + .036 = .100 = 10.0%
Note that this estimate is 200 basis points above the current yield on Taylor's long-term debt
(see Exhibit Four). In our view this is uncomfortably close, and we choose to ignore the DVM
estimate.
(c.) c) 12.76%--or thereabouts--an estimate based on the САРМ.
Question -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.)
The calculation of capital structure at book values yields:
Financing Source $ Amount % of Total
Notes 16,000 7
Bonds 89,000 38
Equity 130,000 55
235,000 100.00
The required return on the short-term debt, KL:
K L=0.07(1−0.4)
¿ 4.2 %
The required return on bonds, Kb:
K b =0.08(1−0.4)
¿ 4.8 %
Assuming Ke of 12.76%, then the required rate of return, K, is estimated by:
K=0.07(4.2 %)+0.38(4.8 %)+0.55(12.76 %)
=0.29%+1.82%+7.02%
K=9.13%
Question -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?
 Consistent Dividends: Most shareholders are attracted to preferred
stocks because they offer more consistent than common shares and higher
payments than bonds.
 Tax Benefit to Corporations: The corporations often receive a tax
advantage on dividends from preferred stock they hold in other
companies, with a substantial portion of these dividends typically
exempt from taxes.
  Investment Diversification: For investor seeking to diversify their
portfolios, preferred stocks can provide a middle ground between
bonds and common equity.
Question -5:
(a) Estimate the cost of preferred stock (required return of
preferred stock).
Using information in Exhibit 6
Preferred Stock Information on Taylor's Competitors

OnpndlPnce Current Price

Super Fords $.50 $40 $S.00

Faston $4J $SJ $2.2.5
Westgote $46 $45 $3.00

Firms Kp Estimate (Dp/Pp)

Super Fords 7.5%
Faston 7.3%
Westgote 6.7%
The average of these estimates is 7.2%.
(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.
Using the target weights given in the question, K is calculated as
follows:
K=0.05(4.2% )+ 0.40(4.8 %)+0.05(8 %)+ 0.50(12.76 % )
¿ 0.21 %+ 1.92% +0.40 % +6.38 %
K = 8.91%

Question -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?
1. Projected Earnings Growth and Current Stock Price:
 Knowing how fast Taylor’s earnings are expected to grow will help us estimate future
dividends. This information is helpful when using models like the Gordon Growth
Model (GGM), which assumes that dividends (a portion of earnings paid to
shareholders) grow steadily over time and constant returns, r.
  Additionally, knowing the current stock price is essential. It helps us calculate the
dividend yield, which is essentially the return you get from owning the stock in terms
of dividends. So, by understanding both the growth rate and the current stock price, we
can make more accurate estimates about the cost of equity.
2. Taylor’s Risk Level (Beta) After Reducing Operating Leverage:
 "Beta" is a measure of how risky Taylor's stock is compared to the market. Taylor has
recently taken steps to reduce its fixed costs, which has lowered its overall business
risk. To reflect this change, we need to calculate a new beta based on this reduced risk
level. This updated beta will give us a more accurate picture of the risk premium that
investors demand for holding Taylor's stock. Ultimately, this will help us estimate the
cost of equity more precisely.
3. Risk Difference for Preferred Stock:
 Taylor doesn’t yet have preferred stock but is planning to issue some. Knowing how
much riskier Taylor is compared to its competitors (who already have preferred stock)
would help set the expected return or yield for Taylor’s new preferred shares. For
example, if Taylor is slightly riskier, the required return on its preferred stock would
likely be higher than that of its competitors.
4. Flotation Costs:
 These are one-time costs Taylor will pay to issue new shares. If we know these costs,
we can add them to the required return, giving a slightly higher but more accurate
estimate for the cost of equity and preferred stock. Ignoring flotation costs is often
okay, but including them would refine our estimates.
5. Industry Rates of Return for Equity and Preferred Stock:
 Knowing the return rates that investors expect in Taylor’s industry gives us a
benchmark to judge if our estimates for Taylor’s cost of equity and preferred stock are
reasonable. These industry rates can be particularly helpful when there are
uncertainties in calculating Taylor’s specific costs.

Question-7:
(a) What would you guess is the market value of the firm's notes payable? Explain.

It is reasonable for the market value of the firm's notes payable is somewhere near its
book value because notes payable are short-term loans, meaning they’ll be paid off soon.
Because they are short-term, their value doesn’t fluctuate as much with interest rate
changes unlike longer-term securities (like bonds), where market prices can vary widely
with changing interest rates. This is because investors know they’ll be paid back soon, so
they don’t demand big price changes to compensate for interest rate risks. So, it’s safe to
say that the market value of these notes is close to their original, or book, value.
(b) Taylor has one long-term debt security outstanding with a
coupon rate of 7 percent. It is a debenture issue maturing in 10
years, and interest is paid semi-annually. Determine the
debenture's current market value assuming that all principal
will be paid in 10 years. Assume also that the bond's semi-
annual required return is 4 percent.
Given Information:
 Coupon Rate: 7% annually
 Book value of Bonds: 89000
 Interest Payment: Semi-annual
 Interest: Since interest is paid twice a year, each payment is
%∗89000
Interest :7 =3115
2
 Maturity: 10 years (20 semi-annual periods).
 PVFA at n=20 and r=4% is 13.59
Face Value
MV =( Interest Payment∗PVFA ) +( )
( 1+r )n
89000
Market Value=3,115∗13.59+ 20
4
(1+ )
100
MV =42,333+ 40,618
MV =$ 82,951
(c) The MV/BV ratio is 1.15. Calculate the market value of Taylor's
stock.
Given Information:
 Book value of common stock: $58,000
 Book value of retained earnings: $72000
 Total Book value: $130,000
 MV: 1.15
'
Market Value of Taylo r s Stock=1.15∗130,000=149,500
(d) Estimate Taylor's cost of capital or required return assuming
that these market values are consistent with the financing
weights desired by management. (You may ignore preferred
stock.)

New Weights using market values:

 Market values are derived from question 6 and 7
 Percentage of total is the MV/Total MV of financing sources*100
 Cost of notes (4.2%), bonds (4.8%) and equity (12.76%) are results from
question 3.
Financing Source $ Amount % of Total
 Notes 16,000 6.44
Bonds 82,951 33.39
Equity 149,500 60.17
248,451 100.00

k =0.0644 ( 4.2 % ) +0.3339 ( 4.8 % ) +0.6017 (12.76 %)

k =9.55 %

Question-8:
(a) Argue for using market values to determine a firm's required
return (cost of capital).
Current Investor Expectations: The book values of the various financial sources listed on
the balance sheet reflect historical amounts, i.e., the amounts raised in the past, whereas,
Market values take real-time information, making it more relevant for determining the firm’s
cost of capital.
Reflects True Economic Value: Market values reflect the prices that investors place on the
firm’s securities, and future cash flows. Thus, reflecting what it takes today to raise funds from
each capital source. It is crucial because cost of capital is a measure which tells us what
investors expect as return, not what has been paid historically.
b) Argue for using book values.
Stability and Consistency: The advantages of book values are that they are steady and hence
easier to use and are less subject to fluctuate daily as much as market values, especially in
volatile markets.
Easier to Calculate and Verify: Book values are much more straightforward as we can
determine them from company’s balance sheet, providing much reliable and simple measure
that doesn’t require continuous market data updating, less complexity in financial analysis

Question-9:
a) Apparently the 30 percent hurdle rate used by Taylor exceeds its
actual cost of capital or required rate of return. Let us suppose a
company errs in the other direction and chooses a hurdle rate
considerably less than its actual cost of capital. What difficulties
could this cause?
 Increased Financial Risk: This could cause much difficulty in the capital budgeting process.
In evaluating alternative investments, it would be difficult to delineate “winner” from
“losers;” most alternatives would look like “winner.” This would almost surely result in the
implementation of many unsound projects, since having created a false sense of financial
security.
Misallocation of Capital: This problem would be compounded by the tendency of managers
to exaggerate the cashflows of their “pet projects” to get them accepted, which do not generate
sufficient returns. This could result in investing in projects that might destroy value since the
returns will not meet the return demanded by the investors.
At a minimum, the value of the firm’s stock will fall. In the extreme, the implementation of
too many unsound projects, could lead to financial embarrassment.
b) West believes that Taylor’s high cost of capital encourages
managers to develop overly optimistic cash flow forecasts. Is a more
accurate cost- of-capital estimate likely to reduce this bias, as he
apparently thinks? Explain your answer.
We do think that a more carefully estimated cost of capital will help much to improve the
accuracy of the cash flow forecasts. The accuracy of the hurdle rates a firm use gives
managers a more precise benchmark against which to evaluate projects.
If Taylor wants less bias in cash flow estimates, other than this, he might also need to find a
way to make managers accountable for their forecasts.
Some types of post-audits, or aligning actual required return with cost of capital should help,
as it reduces the incentive for managers to engage in optimistic forecasting.

Question-10:
a) Suppose that West will present a summary of his findings to senior
management. Would you recommend that he present his estimate of
Taylor's required return (cost of capital) as XX percent, XX.X percent,
or XX.XX percent? That is, how—if at all—would you suggest the
estimate be rounded off? (Keep in mind that he is likely to be
questioned thoroughly by Unruh, who appears skeptical of West's
efforts.)
We would recommend that he round the estimates to the nearest percent. In our Judgement, to
present the estimate to the nearest hundredth or even tenth of a percent, gives a sense of
precision and with the practical need for a usable figure in decision-making, so XX.X percent
would be acceptable if it simplifies communication without sacrificing accuracy.
b) Would you recommend that West use market or book values in his
presentation? Defend your recommendation.
 We recommend he use market values. As mentioned in Q-8-a they provide a current, realistic
assessment of the firm’s cost of capital, as they reflect the current risk and return expectations
of investors. These strike us as important advantages if West is to be successful in convincing
senior management that his method would paint the most accurate picture of what would it
cost to raise new capital today. Stated differently, using market values demonstrates up-to-date
analysis, which might help address the management’s lack of conviction by showing that the
estimate is grounded in current market realities rather than historical data that may no longer
be relevant.