Sara Dylan, recently graduated with a degree in Finance, was offered a job as a treasury analyst in ABS car manufacturer. As she started her job, Sara thought the company’s prospects were good. ABS was a mature business that had grown steadily at the expense of its less-well-known competitors. Sara started work on January 2, 2018. The first 2 weeks went smoothly. Then (Sara’s manager) Mr. Ward’s cost of capital memo assigned her to explain the ABS weighted average cost of capital to other managers. Sara first examined ABS’s most recent balance sheet, summarized in Table 1. Then she made the following additional points: 

• Interest rates were charged at the current rate by the lenders, and the long-term debt had just been issued. There is no significant difference between the Book and market values. 

• The preferred stocks had been issued 35 years ago, when interest rates were much lower. Back then, the book value of the preferred stock was £100 per share, but now trading for only £70 per share. 

• The common stock traded for £40 per share. 

• Next year’s earnings per share would be about £4 and dividends per share probably £2. (Ten million shares of common stock are outstanding.) 

• ABS had traditionally paid out 50% of earnings as dividends and plowed back the rest. 

• Earnings and dividends had grown steadily at 6% to 7% per year, in line with the company’s sustainable growth rate:

ABS’s beta had averaged about 0.5, which made sense, Sara thought, for a stable, steady-growth business. Assume the current interest rate of 7% and the market risk premium is 7%. Prepare a presentation to Mr. Ward (Sara’s boss); in your presentation, make sure you address the points 1-3. Remember your job is not just finding the right number, you also need to figure out how to explain it all to Mr. Ward and the mangers.

1- Find and explain the relevant cost of equity using the Capital Asset Pricing Model. In your answer, you need to make sure you explain the CAPM, the mode’s parameters and then interpret the model’s output.
 

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Table 1. ABS balance sheet, taken from the company's 2017 balance sheet (figures in £millions) Working capital £200 360 £120 80 Bank loan Plant and Long-term debt equipment Other assets 40 Preferred stock 100 Common stock, retained earnings Total 300 Total 2600 E600 Notes: 1- At year-end 2017, Sea Shore Salt had 10 million common shares outstanding. 2- The company had also issued 1 million preferred shares with book value of £100 per share. Each share receives an annual dividend of £6. Table 1. ABS balance sheet, taken from the company's 2017 balance sheet (figures in £millions) Working capital £200 360 £120 80 Bank loan Plant and Long-term debt equipment Other assets 40 Preferred stock 100 Common stock, retained earnings Total 300 Total 2600 E600 Notes: 1- At year-end 2017, Sea Shore Salt had 10 million common shares outstanding. 2- The company had also issued 1 million preferred shares with book value of £100 per share. Each share receives an annual dividend of £6.

Answer rating: 100% (QA)

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