BUS 330: Corporate Finance I

Case #04

Can One Size Fit All?

The Oceanic Corporation, a Chesapeake, VA based company, was established in 1994. Glenn Rod ers !!! "o#nded the corporation, which was pri$ately owned at the time, a"ter his retirement "rom %orentech Corporation. The Oceanic Corporation was ori inally "ormed to pro$ide ship repair ser$ices and &#ickly earned a 'epartment o" 'e"ense ('O') certi"ied Alteration *oat Repair (A*R) desi nation. Amon its specialties were str#ct#ral weldin , pipin system installation and repairs, electrical, paintin , ri in , machinery and dry+lock work, as well as c#stom sheet metal "abrication. Other di$isions o" The Oceanic incl#ded ,abitability !nstallation, !nd#strial Contractin , and Alteration-!nstallation Teams (A!T). .ith its initial s#ccess and ood ret#rn on in$estment the "irm opened and operated "acilities in Cali"ornia, %ew /ersey, 0lorida, 1aryland, 2ennsyl$ania and .ashin ton. !n 1993, the company went p#blic and its initial p#blic o""erin was $ery s#ccess"#l. The stock price had risen "rom its initial $al#e o" 415 to its c#rrent le$el o" 467 per share. There were c#rrently 7 million shares o#tstandin . !n 1999, the company iss#ed 65+year bonds at par, with a "ace $al#e o" 41555 and a co#pon rate o" 158 per year, and mana ed to raise 445 million "or e9pansion. C#rrently, the AA+rated bonds had :7 years le"t #ntil mat#rity and were bein &#oted at 91.78 o" par. O$er the past year, the Oceanic Corporation #tili;ed a new method "or "abricatin composite materials that the "irm<s en ineers had de$eloped. !n /#ne o" last year, mana ement established the Ad$anced 1aterials Gro#p (A1 Gro#p), which was dedicated to p#rs#in this technolo y. The "irm recr#ited =arry >tone, a senior en ineer, to head the A1 Gro#p. =arry also had an 1*A "rom a presti io#s #ni$ersity #nder his belt. ?pon @oinin Oceanic, =arry reali;ed that most pro@ects were bein appro$ed on a A #t "eelB approach. There were no "ormal acceptance criteria in place. ?p #ntil then, the company had been l#cky in that most o" its pro@ects had been well selected and it had bene"ited "rom ood relationships with clients and s#ppliers. AThis has to chan e,B said =arry to his assistant >tephanie, Awe can<t possibly be this l#cky "ore$er. .e need to calc#late the "irm<s h#rdle rate and #se it in the "#t#re.B >tephanie 2hillips, who had reat admiration "or the boss, replied, ACes, =arry, why don<t ! cr#nch the n#mbers and i$e them to yo# within the ne9t co#ple o" daysDB AThat so#nds reat, >tephanie,B said =arry. A1y years o" e9perience tell me that when it comes to the h#rdle rate "or new pro@ects, one si;e hardly e$er "its it allEB As >tephanie be an lookin at the "inancial statements, she reali;ed that she was oin to make some ass#mptions. 0irst, she ass#med that she ass#med that the new debt wo#ld cost abo#t the same as the yield on o#tstandin debt and wo#ld ha$e the same ratin . >econd, she ass#med that the "irm wo#ld contin#e raisin capital "or "#t#re pro@ects by #sin the same tar et proportions as determined by the book $al#es o" debt and e&#ity (see Table 1 "or recent balance sheet). Third, she ass#med that the e&#ity beta (1.7) wo#ld be the same "or all the di$isions. 0o#rth, she ass#med that the rowth rates o" earnin s and di$idends wo#ld contin#e at their historical rate (see Table :, "or earnin s and di$idend history). 0i"th, she ass#med that the corporate ta9 rate wo#ld be 648 and "inally, she ass#med that the "lotation cost "or debt wo#ld be 78 o" the iss#e price and that "or e&#ity wo#ld be 158 o" sellin price. The 1+year Treas#ry bill yield was 48 and the e9pected rate o" ret#rn on the market port"olio was 158.

BUS 330: Corporate Finance I Questions: F1.

Case #04

.hy do yo# think =arry >tone wants to estimate the "irm<s h#rdle rateD !s it @#sti"iable to #se the "irm<s wei hted a$era e cost o" capital as the di$isional cost o" capitalD 2lease e9plain. ,ow sho#ld >tephanie o abo#t "i #rin o#t the cost o" debtD Calc#late the "irm<s cost o" debt. Comment on >tephanie<s ass#mptions as stated in the case. ,ow realistic are theyD .hy is there a cost associated with a "irm<s retained earnin sD ,ow can >tephanie estimate the "irm<s cost o" retained earnin sD >ho#ld it be ad@#sted "or ta9esD 2lease, e9plain. Calc#late the "irm<s a$era e cost o" retained earnin s. Can "lotation costs be i nored in the analysisD I9plain. ,ow sho#ld >tephanie calc#late the "irm<s h#rdle rateD Calc#late it and e9plain the $ario#s steps. Can =arry ass#me that the h#rdle rate calc#lated by >tephanie wo#ld remain constantD 2lease e9plain. Table T!e Oceanic Corporation Balance S!eet "#000s$

F:. F6. F4. F7. FG. FH. F3. F9.

Cash 7555 Acco#nts Recei$ables 15555 !n$entory :5555 Total Current Assets 35000 =and J *#ildin s (net) 46555 2lant and I&#ipment (net) Total Fixed Assets 88000 Total Assets %3000

Acco#nts 2ayable Accr#als %otes 2ayable 15555 Total Current Liabilities 23000 =on +term debt 45555 Common stock (5 million shares outstanding) 47555 Retained Iarnin s Total liabilities an& e'uit(

3555 7555

75555 15555 %3000

BUS 330: Corporate Finance I

Case #04

Table % T!e Oceanic Corporation Sales) *arnin+s) an& ,i-i&en& .istor( "#000s$ Sales *arnin+s per s!are 4:4,555,555 45.43 :3,355,555 5.73 6G,555,555 5.H: 47,555,555 5.3G 71,H75,555 5.9G G:,155,555 1.5G H4,7:5,555 1.:5

/ear 1993 1999 :555 :551 :55: :556 :554

,i-i&en&s per s!are 45.15 5.1: 5.17 5.13 5.:5 5.:: 5.:7