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Case 42

West Coast Semiconductor, Inc.

Cost of Capital
Directed

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West Coast Semiconductor (WCS) was founded in Palo Alto, California, in 1984 by a team of
engineers led by Frank Reed. Reed took early retirement that year from his position as an engineering professor at a major West Coast university. During his tenure at the university, Reed was actively
involved in semiconductor research, and he was a consultant to several firms in the industry.
WCS started with a $500,000 investment from its founders and a $4.5 million design contract from a leading cellular telephone company. WCS soon parlayed its scientific skills and Reeds
familiarity with the industry into a thriving business, and in 1987 the company built a state-of-theart manufacturing plant at a cost of $100 million. The necessary capital was obtained from venture
capitalists and commercial banks. WCS has since produced and marketed a broad range of computer
chips for commercial use in the semiconductor market, primarily to makers of cellular telephones
and laptop computers. Continued innovation in its memory and logic products, along with a rapid
expansion in the market for these products, has resulted in high profitability and very rapid growth.
By 1989, WCSs growing capital needs could no longer be met by internal funds, venture capital,
and its ability to borrow, so the company went public. Currently, WCS shares trade in the over-thecounter market, and they have been selling at about $22 per share.
Since the companys inception, Frank Reed has been directly and tirelessly involved in all
facets of the business. He is satisfied with the product development, manufacturing, and marketing
aspects of the business, and he is quite comfortable with his ability to evaluate and guide these activities. However, he has become increasingly uneasy about the finance function, in which he has no
special expertise. With the rapid growth in the scope and size of the business, financial decisions
have become increasingly complex. Further, competition in the lucrative cellular telephone market
from such established firms as Texas Instruments, Intel, and National Semiconductor has also been
increasing. By 1995 Reed realized that, to ensure continued success, he had to establish a finance
group that was as competent and sophisticated as those of his competitors. Therefore, in late 1995,
he hired Thomas Kennedy, a senior financial executive of a competing firm, to head the finance
group at WCS.
Kennedys first task was to review the existing capital investment procedures and to report
his findings and recommendations to WCSs board of directors. In going over the procedures manuals and the supporting analyses for recent capital investment decisions, Kennedy quickly saw that
the overall procedures were generally appropriate: The firm relied primarily on the Net Present
Value criterion to arrive at accept/reject decisions for most projects; it estimated future cash flows on
an incremental basis; and it discounted cash flows at the firms weighted average cost of capital.
However, the cost of capital estimation techniques was questionable. In the most recent capital

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Copyright 1994. The Dryden Press. All rights reserved.

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budgeting exercise, at year-end 1994, the treasurer used a before-tax debt cost of 9.5%, which was
equal to the coupon rate on the most recent (1992) long-term bond issue. The bond rating in 1994, as
in 1992, was A. For the cost of equity, the treasurer used the year-end earnings yield (E/P) of
12.27%, based on an earnings per share of $2.70 and a share price of $22.
Just before the winter holidays, the treasurer resigned, and Kennedy called upon Jane Porter,
a recently hired MBA from UC-Berkeley, to conduct a complete cost-of-capital analysis as of yearend 1995, and also to provide a critical evaluation of the current estimation procedures.

TABLE 1

West Coast Semiconductor, Inc.: Balance Sheet

for the Year Ended December 31, 1995
(In Millions of Dollars)

Cash and securities

Accounts receivable
Inventory
Current Assets
Net fixed assets

$ 15.3
50.2
10.6
$ 76.1
220.5

Total assets

$296.6

Accounts payable
Accruals
Notes Payable
Current liabilities
Long-term debt
Preferred stock
Common stock
Retained earnings
Total claims

8.0
8.6
3.5
$ 20.1
98.2
35.6
40.0
102.7
$296.6

Porter first reviewed the 1995 balance sheet, which is summarized in Table 1. Next, she assembled the following data:
(1)

The bond quote on WCSs long-term, semi-annual bond as reported in the financial press is as follows:

Bonds
WCS 9 12s15

Cur Yld
9.9

Vol
28

Close
95 34

Net Chg
+18

(2)
Quotes on WCSs common and preferred stock were as follows:
52 Weeks

Hi
23 12
108 14

Lo
19 38
100 12

(3a)

Sym
WCSA

Div
1.0
9.0

y/d
%
4.4
8.6

PE
7.5

Vol
100s
356
87

Hi
22 34
104 14

Lo
22 12
103 34

Close
22 34
104 14

Net
Chg
+ 14
18

Quotes on long-term Treasury bonds were obtained from The Wall Street Journal:
Maturity
Mo. /Yr.
Dec. 05
Dec. 15
Dec. 25

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Coupon
Rate
6 58
8 78
8 14

Stock
WCS
WCSpf

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Bid
92:27
109:02
99:11

Asked
92:29
109:05
99:14

Chg
2
+1
1

Ask Yld
7.67
7.96
8.30

Days
to Mat
91
178
273

Bid
5.23
5.48
5.61

Asked
5.19
5.46
5.59

Chg
.02
+.04
.03

Ask Yld
5.34
5.69
5.92

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Maturity
Mar 31
Jun 26
Sep 29

Quotes on Treasury bills were also obtained from The Wall Street Journal:

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(3b)

(4) WCSs federal-plus-state tax rate is 40 percent.

(5) The firms last dividend (D0) was $l.00, and recent dividends have been growing at a
rate of about 10.5 percent. Some analysts expect the recent growth rate to continue,
while others expect it to go to zero as new competition enters the market, but the majority anticipate a growth rate of about 10 percent for the indefinite future. The company
has 8.0 million common shares outstanding.
(6) A prominent investment banking firm recently estimated that the market risk premium
is 6 percentage points over Treasury bonds. WCSs historical beta, as measured by
several analysts who follow the stock, is 1.1.
(7) The going interest rate on average A-rated long-term bonds is 10.0 percent.
(8) WCS is forecasting earnings of $26,400,000 and depreciation of $6,000,000 for the
coming year. About one-third of earnings will be paid out as dividends.
(9) WCSs investment bankers believe that a new issue of common stock would involve
total flotation costsincluding underwriting costs, market pressure from increased supply, and market pressure from negative signaling effectsof 30 percent. Preferred stock
would have a flotation cost of $2 per share.
(10)The market value target capital structure calls for 20 percent long-term debt, 10 percent
preferred stock, and 70 percent common equity.

Porter then answered the following set of questions to complete her assigned task.

QUESTIONS

1. a. Critique WCSs current method of estimating its before-tax cost of debt.

b. Is earnings yield (E/P) an appropriate measure of the firms cost of equity?
2. a.
b.
c.
d.

What is your estimate of WCSs cost of debt?

Should flotation costs be included in the component cost of debt calculation? Explain.
Should the nominal cost of debt or the effective annual rate be used? Explain.
How valid is an estimate of the cost of debt based on 20-year bonds if the firm plans to
issue 30-year long-term debt? If you believe the estimate is not valid, what could be done
to make the 20-year cost a better proxy for the 30-year cost?
e. Suppose WCSs outstanding debt had not been recently traded; what other methods could
be used to estimate the cost of debt?
f. Would it matter if the currently outstanding bonds were callable?

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3. a. What is the estimate of the cost of preferred stock?

b. WCSs preferred stock is more risky to investors than its debt, yet its before-tax yield to
investors is lower than the yield on WCSs debt. Why does this occur?

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c. If WCSs preferred stock had a mandatory redemption provision which specified that the
firm must redeem the issue in 5 years at a price of $110 per share, what would WCSs
cost of preferred be ?

4. a. Why is a cost associated with retained earnings?

b. What is WCSs estimated cost of retained earnings, using the CAPM approach?
c. Why might the T-bond rate be a better estimate of the risk-free rate than the T-bill rate?
Is there an argument that would favor the use of the T-bill rate?
d. How do historical betas, adjusted historical betas, and fundamental betas differ? Would
WCSs historical beta be a better or a worse measure of WCSs future market risk than
the historical beta for an average NYSE company would be for its (the average NYSE
companys) future market risk? Explain.
e. What are some alternative ways to obtain a market risk premium for use in a CAPM costof-equity calculation? Discuss both the possibility of obtaining an estimate from some
other organization and also the ways in which WCS could calculate a market risk premium in-house. Would historical data be useful here?
5. a. What is the discounted cash flow (DCF) estimate of WCSs cost of retained earnings?
b. Suppose WCS, over the last few years, has had a 14.5 percent average return on equity
(ROE) and has paid out about 33 percent of its net income as dividends. Under what conditions could this information be used to help estimate the firms expected future growth
rate, g? Estimate ks using this procedure for determining g.
c. The firms dividends per share over the past 5 years are as follows:
Year
1991
1992
1993
1994
1995

Dividend
$0.68
0.75
0.85
0.95
1.00

What was the firms historical dividend growth rate using the point-to-point method?
Using linear regression?

6. Use the bond-yield-plus-risk-premium method to estimate WCSs cost of retained earnings.

7. Based on all the information available, what is your final estimate for ks? Explain how you
decided to weight each estimating technique.
8. What is your estimate of WCSs cost of new common stock, kc? What are some potential
weaknesses in the procedures used to obtain this estimate?

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9. a. Construct WCSs marginal cost of capital (MCC) schedule. How large could the companys capital budget be before it is forced to sell new common stock? Ignore depreciation at this point.
b. Would the MCC schedule remain constant beyond the retained earnings break point, no
matter how much new capital it raised? Explain. Again, ignore depreciation.
c. How does depreciation affect the MCC schedule? If depreciation were simply ignored,
would this affect the acceptability of proposed capital projects? Explain.

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10. Should the corporate cost of capital as developed above be used for all projects? If not, what
type of adjustment should be made?

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11. a. What are WCSs book value weights for debt, preferred stock, and common equity, considering only long-term sources of capital?
b. What are WCSs market value weights for debt, preferred stock, and common equity?
c. Should book value or market value weights be used when calculating the firms weighted
average cost of capital? Why?

1996 South-Western, a part of Cengage Learning

 1996 South-Western, a part of Cengage Learning

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