## cost of capital

Two-part assignment not less than 8 pages in total

No plagiarism

Part 1

You are discussing your 401(k) with Dan Ervin when he mentions that Sarah Brown, a rep resentative from Bledsoe Financial Services, is visiting East Coast Yachts today. You decide that you should meet with Sarah, so Dan sets up an appointment for you later in the day.

When you sit down with Sarah, she discusses the various investment options available in the company’s 401(k) account. You mention to Sarah that you researched East Coast Yachts before you accepted your new job. You are confident in management’s ability to lead the company. Analysis of the company has led to your belief that the company is growing and will achieve a greater market share in the future. You also feel you should support your employer. Given these considerations, along with the fact that you are a conservative investor, you are leaning toward investing 100 percent of your 401(k) account in East Coast Yachts stock.

Assume the risk-free rate is 3.2 percent. The correlation between the Bledsoe bond fund and large-cap stock fund is 0.15. Note that the spreadsheet graphing and “solver” functions may assist you in answering the following questions.

- Considering the effects of diversification, how should Sarah respond to the suggestion that you invest 100 percent of your 401(k) account in East Coast Yachts stock?
- Sarah’s response to investing your 401(k) account entirely in East Coast Yachts stock has convinced you that this may not be the best alternative. Because you are a conservative investor, you tell Sarah that a 100 percent investment in the bond fund may be the best alternative. Is it?
- Using the returns for the Bledsoe Large-Cap Stock Fund and the Bledsoe Bond Fund, graph the opportunity set of feasible portfolios.
- After examining the opportunity set, you notice that you can invest in a portfolio consisting of the bond fund and the large-cap stock fund that will have exactly the same standard deviation as the bond fund. This portfolio also will have a greater expected return. What are the portfolio weights and expected return of this portfolio?
- Examining the opportunity set, notice there is a portfolio that has the lowest standard deviation. This is the minimum variance portfolio. What are the portfolio weights, expected return, and standard deviation of this portfolio? Why is the minimum variance portfolio important?
- A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The portfolio with the highest possible Sharpe ratio on the opportunity set is called the Sharpe optimal portfolio. What are the portfolio weights, expected return, and standard deviation of the Sharpe optimal portfolio? How does the Sharpe ratio of this portfolio compare to the Sharpe ratios of the bond fund and the large-cap stock fund? Do you see a connection between the Sharpe optimal portfolio and the CAPM? What is the connection?

Part 2

You have recently been hired by Master Tools (MT) in its relatively new treasury management department. MT was founded eight years ago by Martha Masters. Martha found a method to streamline the manufacturing process, resulting in a cheaper tool. The tools manufactured by MT are designed for the mass market and sold primarily through retail. The company is privately owned by Martha and her family, and it had sales of $97 million last year.

MT primarily sells to do-it-yourself (DIY) customers who use the tools for personal projects, although it does sell through various online marketplaces. As a result, the company’s sales are price sensitive. When the company had sufficient capital, it would expand production. Relatively little formal analysis has been used in its capital budgeting process. Martha has just read about capital budgeting techniques and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Martha would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. Martha wants you to use the pure play approach to estimate the cost of capital for MT, and she has chosen Snap-On Incorporated as a representative company. The following questions will lead you through the steps to calculate this estimate.

- Most publicly traded corporations are required to submit 10-Q (quarterly) and 10-K (annual) reports to the SEC detailing their financial operations over the previous quarter or year, respectively. These corporate filings are available on the SEC website at www.sec. gov. Go to the SEC website, follow the “Company Filings” link, and search for SEC filings made by Snap-On (SNA). Find the most recent 10-Q and 10-K and download the forms. Look on the balance sheet to find the book value of debt and the book value of equity.
- To estimate the cost of equity for SNA, go to
**finance.yahoo.com**and enter the ticker symbol “SNA.” Follow the various links to find answers to the following questions: What is the most recent stock price listed for SNA? What is the market value ofequity, or market capitalization? How many shares of stock does SNA have outstanding? What is the forward annual dividend? Analysts have estimated a 6 percent growth rate for dividends. What is the cost of equity for SNA using the DDM? What is the beta for SNA? Now go back to**finance.yahoo.com**and follow the “Bonds” and “U.S. Treasury Bonds Rates” links. What is the yield on 3-month Treasury bills? Using the historical market risk premium, what is the cost of equity for SNA using the CAPM? What is your final estimate for the cost of equity? - Go to www.reuters.comand find the list of competitors in the industry. Find the beta for each of these competitors and then calculate the industry average beta. Using the industry average beta, what is the cost of equity? Does it matter if you use the beta for SNA or the beta for the industry in this case?
- You now need to calculate the cost of debt for SNA. Go to
**finra-markets.morningstar. com/BondCenter,**enter SNA as the company, and find the yield to maturity for each of SNA’s bonds. What is the weighted average cost of debt for SNA using the book value weights and the market value weights? Does it make a difference in this case if you use book value weights or market value weights? - You now have all the necessary information to calculate the weighted average cost of capital for SNA. Calculate the weighted average cost of capital for using book value weights and market value weights assuming 21 percent marginal tax rate. Which cost of capital number is more relevant?
- You used SNA as a representative company to estimate the cost of capital for MT. What are some of the potential problems with this approach in this situation? What improvements might you suggest