Cost of Capital on Trans Pacific Industry and Technology
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Trans-Pacific Industry & Technology (TPIT), Inc. is a diversified industrial company. The Company owns businesses providing products & services to the energy, transportation, chemical, and construction sectors.
The energy segment operates as an oil and natural gas contract drilling company the United States. The energy segment acquires, explores, develops, and produces oil and natural gas properties primarily located in Oklahoma and Texas, as well as in Arkansas, Colorado, Kansas, Louisiana, Mississippi, Montana, New Mexico, North Dakota, Utah, and Wyoming. This segment generated over $10 billion of revenue in 2016.
The transportation segment is among the largest public railroad in North America. Operating on 12,000 miles of track in the western one thirds of the U.S., This segment generated over $20 billion of revenue in 2016 by hauling coal, industrial products, intermodal containers, agriculture goods, chemicals, and automotive goods.
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The chemical segment sells value-added chemicals, thermoplastic polymers, and other chemical-based products worldwide. This segment develops, produces, and supplies specialty polymers for automotive and medical applications, as well as for use in industrial products and consumer electronics. This segment generated over $5 billion of revenue in 2016.
The Construction segment produces and sells specialty construction chemicals, specialty building materials, and packaging sealants and coatings. The Company operates through two segments: Specialty Construction Chemicals and Specialty Building Materials. The Specialty Construction Chemicals segment manufactures and markets products to manage performance of Portland cement, and materials based on Portland cement, such as concrete admixtures and cement additives, as well as concrete production management systems. The Specialty Building Materials segment manufactures and markets building envelope products, residential building products and specialty construction products. This segment generated over $5 billion of revenue in 2016.
During the last few years, Trans-Pacific Industry has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. The expansion requires investment in eight projects from the four segments. Table-1 provides information about the projects.
Assume that you are an assistant to Jim Jones, the financial vice president. Your first task is to estimate TPIT’s cost of capital.
As a part of your analysis you have collected the following data:
(1) The firm’s tax rate is 40%.
(2) The current price of TPIT 12% coupon, semiannual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. TPIT does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
(3) The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. TPIT would incur flotation costs equal to 5% of the proceeds on a new issue.
(4) TPIT’s common stock is currently selling at $50 per share. Its last dividend was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the foreseeable future. TPIT’s beta is 1.2, the yield on T-bonds is 5.6%, and the market risk premium is estimated to be 6%.
(5) Suppose the firm has historically earned 15% on equity (ROE) and retained 35% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5.8% growth rate given earlier?
(6) TPIT’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
a. What sources of capital should be included when you estimate TPIT’s weighted average cost of capital (WACC)?
b. Should the component costs be figured on a before-tax or an after-tax basis?
c. Should the costs be historical (embedded) costs or new (marginal) costs? Explain?
d. TPIT’ preferred stock is riskier to investors than its debt, yet the preferred yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)
e. What is the market interest rate on TPIT’s debt and what is the component cost of this debt for WACC purposes?
f. What is the corporate cost of capital?
Jim Jones was worried that whether the corporate cost of capital would be appropriate to evaluate the four segments’ project. His concern centered onwhether the risk of the projects is reflected on the corporate cost of capital? What is the logical method of adjusting the cost of capital for risk? Is it wise to use the corporate cost of capital to evaluate the four segments’ projects?
1. Discuss the quantitative methods that are useful to evaluate the projects?
2. Discuss the strengths and weakness of each quantitative method you have selected to evaluate the projects?
3. Will all of the quantitative methods rank the projects identically? Why or why not?
4. Rank the projects on the basis of the measurements discussed above