Sample Finance Case Study Paper on Taylor Brands

Taylor Brands

  1. It is appropriate for the west to adjust the firm’s beta downwards in light of the firm operating leverage decreasing. The reason is that the beta of the firm indicates how the firm is affected by changes in the market. Therefore decreasing the operating leverage will reduce the effects changes in the market have on the firm. Reducing the operating leverage of the firms means that the firm is reducing the risks that the firm can face from general movements in the market. Using this information, its rationale for the west is to reduce the beta of the firm.
  2. (a.) risk premium approach

Re = rf + (rm – rf) * β

Rf = 5.5%

Rm = 8%

β =  = 1

Re = 5.5% + (8% – 5.5%) * 1

= 8%

(b.) dividend valuation model

Re =

Next year dividends = 0.45

Value of stock =  = 32

Dividend growth rate = 4.5%

Re =  = 5.91%

(c.) Preferred cost of equity

The most realistic cost of equity is the one given by the risk premium approach. This is because the company dividend payout is biased and using the dividend valuation method will only provide misleading information. This formula is too sensitive to changes in dividends growth rate causing it to be vulnerable to small changes in growth. Therefore, the risk premium is the better choice to estimate the cost of equity for the Taylor brand.

Cost Of Capital
Equity Formula Cost Of Capital
Common stock Re = rf + (rm – rf) * β 5.5% + (8% – 5.5%) * 1 8%
Retained earnings long term bond yield + risk premium 8% + 5.5% 13.50%
Bonds Rd (1-tc) 8% (1-0.4) 4.80%
Notes payable Rd (1-tc) 7% (1-0.4) 4.20%
Weights Of Equity
Amount Weight
common stock 58,000 24.7
retained earnings 72,000 30.6
bonds 89,000 37.9
Notes payable 16,000 6.8
235,000 100
Weighted Average Cost Of Capital
Equity Cost of capital Weights WACC
Common stock 8% 24.7 1.98
Retained earnings 13.50% 30.6 4.13
Bonds 4.80% 37.9 1.82
Notes payable 4.20% 6.8 0.28
8.21
  1. (b.) Preferred stock estimate

Considering the competitor’s preferred stock dividend, Taylor will probably pay its preferred shareholders a lower dividend of $2. This is based on Taylor’s strategy of reinvesting most of its profits. The preferred stock price for Taylor can be arrived at by finding the average market price for its competitors.

The preferred stock price for Taylor    =

=  = $38

Rps =

Rps=  = 5.3%

(b.) Weighted Cost of Capital

Weighted Average Cost Of Capital
Equity Cost of capital Weights WACC
Common stock 8% 50% 4
preferred stock 5.30% 5% 0.27
Bonds 4.80% 40% 1.92
Notes payable 4.20% 5% 0.21
6.4
  1. Additional information required

West should have included in his information the number of common shares that Taylor has. Using the number of common shares, the market value of the shares would have been calculated instead of estimating it. Therefore, the number of common shares would be helpful and would provide a more accurate cost of equity estimation. Instead of providing the number of common shares, the price of the common stock would also be helpful. Furthermore, additional information about the number and the price of the preferred share would be helpful in ascertaining the cost of capital. This is because the preferred cost of capital was based on complete estimates and industry averages.

  1. (a.)

Note payables are short-term debts and need to be repaid within a period of less than one year. In this scenario, we are not given the exact date when Taylors note [payable is due, therefore it will be safe to assume that the notes payable are due within exactly one year. With this information, we can calculate the value of the note payable plus its interest using the formula P * R * T

Notes payable interest = 16,000 * 7% * 1

= $ 1120

Notes payable amount = principle + interest

= 16,000 + 1120

= 17,120

(b.)     Calculations for present value of interest payments

n = 20 semiannual periods

I = 4% per semiannual period

Semi annual interest payment (PMT) = 89,000 * 7% *  = $3115

Present value of annual interest payment = PMT * PVOA for n=20, i= 4%

PV = $42,333.87

Calculations for present value of principle amount

Present value for principle amount = FV * PVF for n= 20, i= 4%

PV = $40,618.44

Debenture current market value = 42,333.87 + 40, 618.44

= 82,952.31

(c.)     MV/BV = 1.15

BV = MV * 1.15

BV = 82,952.31 * 1.15

BV = $95395.16

(d.)

Weights Of Equity
Amount Weight
common stock 58,000 0.25
retained earnings 72,000 0.32
bonds 82,952 0.36
Notes payable 16,000 0.07
228,952 1
Weighted Average Cost Of Capital
Equity Cost of capital Weights WACC
Common stock 8% 0.25 2
Retained earnings 13.50% 0.32 4.32
Bonds 4.80% 0.36 1.73
Notes payable 4.20% 0.07 0.29
8.34
  1. (a.) Market values

Using market value allows a firm’s ability to generate earnings to be reflected in the valuations. It also allows the expected cash flows from the operations of the business to be reflected in the valuations of the firm.

(b.) Book values

Estimation using book values are quite stable and are not affected by changes in the business environment. Book value can prevent a firm from going bankrupt due to negative speculations in the market.

Proper accounting standards provide an avenue where all the firms in the same industry can calculate their book values in a similar way. If these standards are consistent then the book values can be used for comparison purposes and will help determine firms that are under or overvalued.

Book value estimates allow firms that are suffering from negative earnings to be valued. This is because negative values will not provide a true value of the firm when price-earnings ratios are used. This however is not the case when firms for valuation purposes use book values.

  1. (a.)

The cost of capital is instrumental in deciding the type of projects that a firm will undertake. Choosing a lower cost of capital than the actual cost of capital will mean that the firm will choose projects that cannot pay its cost of capital. This means that the returns generated from a project will be lower than the returns needed to pay the cost of capital and remain as profits. The returns of the project will therefore be unable to break even causing the firm to incur losses because of that project.

(b.)

A more accurate cost of capital will reduce the need for managers to develop overly optimistic cash flow forecasts. Since the accurate cost of capital is lower than the one projected by Unruh, then managers will not have to develop optimistic cash flow forecasts so that their project can break even. With a lower cost of capital, it will be easier for normal cash flow to meet the required rate of return and therefore be viable for the undertaking. This freedom will allow managers to act accordingly when it comes to cash flow projections.

  1. (a.)

The cost of capital for Taylor should be rounded off to two decimal places. The reason why a two decimal place is effective is that Taylor’s capital is huge. This means that a difference of (.XX) is big enough to warrant consideration. By rounding off to one or zero decimal places, then the company can fail to break even because of that one or zero point one percent that is ignored through rounding off.

(b.)

West should use market values when presenting his report to Unruh. The reason is that market value gives the best estimate for raising capital in the current period. When one se book value, it is the same as estimating the cost of capital of already existing debt, which is not the same as the cost of capital for required debt. Therefore, for more accuracy and provision of relevant information then West should use market value to present his repo