Silicon Valley Medical Financial Analysis
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In SIVMED’s case, based on the definition of WACC, all capital bases should be included in its WACC. These include its common stock, preferred stock, bonds and long-term borrowings. In addition to being able to compute for the costs of capital, the WACC also determines how much interest SIVMED has to pay for all its activities. The value of the firm’s stock, which we want to maximize, depends of the after-tax cash flow. Hence, after-tax values for WACC are also needed. Furthermore, cost of capital is used to determine the cost of each debt, stock or common equity. Being able to analyze these will be essential into deciding what and how new capital should be acquired. Hence, the present marginal costs are ideally more essential than historical costs.
a. SIVMED’s cost of debt is at 6.6% [See Appendix 2a]
b. Yes, flotations should be part of the calculation of debt cost. This is because Flotation costs are typically included in the component of debt calculation as a part of calculating the nominal rate of the debt’ cost, which cover both underwriting spread and the costs paid by the issuing company.
c. The EAR (6.6%) can deal with debts of different payment frequencies. Nonetheless, nominal rates should be used because the total costs, which are naturally small on public debt issues, decrease the net proceeds from the sale.
d. Coupon rates differ from a 15-year bonds and 30-year bonds because we consider the risk of the bond. Usually, the longer the time for maturity, naturally, the higher the risk, hence, generally, the higher cost of debt. Thus, the estimate is not valid. To make it more valid, though, we need to adjust the yield curve calculated using the 15-year bond to a calculation using a 30-year bond.
e. A way to calculate the cost of debt when the outstanding debt has not been traded is to use a synthetic rating based upon the company’s financial ratios (ie the interest coverage ratio). By getting a default spread based on the ratio and adding the risk-free rate, an updated pre-tax cost of debt estimate is going to surface.
f. It would matter because a callable bond, a bond which can be bought back by the issuer before its maturity, can reduce the cost of debt when the interest rate decreases.
Hence, the company can reissue them at a lower interest rate when they are reacquired.
a. SIVMED’s cost of preferred stock is 9.8%. [See Appendix 3a]
b. There are two possibilities. One is that the company is rumoured or actually not performing well in terms of its income stream for the past several years. They will borrow money to cover any shortfall in their income flow. Another is that most of the preferred stock is already owned by the company such that most of the preferred dividends do not go to the investors. This makes it possible for the before tax yield of debt to exceed that of preferred stock.
c. The cost of preferred stock in this case is 10.87% [See Appendix 3c]. Hence, SIVMED will have a higher cost of preferred stock with a mandatory redemption provision.
a. This cost reflects the opportunity cost the company incurs when it decides to retain its earnings. That is, the company could have given dividends to its bondholders and preferred and common stockholders, and these people could have put this money into other investments.
b. Using the CAPM approach, SIVMED’s cost of retained earnings is 15.2%. [See Appendix 4b]
c. The T-Bond rates is generally a better estimate of the risk-free rate because transactions under the T-Bond rate are greater in denomination and longer maturity periods. However, one could also argue that T-Bills are more reliable since they do not carry any maturity risk.
d. Historical betas are past standard deviations of one security; adjusted historical betas approximate securities’ future betas; and fundamental betas are betas that are adjusted using economic information to. (NYSE part of the question is N/A.)
e. One way is for the company to get analysts to calculate the expected rate of return, and simply subtract the current risk-free rate. The other way is obtain other competing companies’ discounted cash flow and deduct the T-Bond yield.
a. Using the Discounted Cash Flow Method, SIVMED’s cost of retained earnings is 14.8%. [See Appendix 5a]
b. The estimated growth rate was computed for using a method involving retention rate or its complement, the payout rate. It was computed to be 10.5%. In using this estimated growth rate, the return on equity was computed to be 15.30%. [See Appendix 5b]
c. The dividend growth rate was acquired through the use of percentage change, or in this case increase, in the dividends throughout the years. The dividend growth rates are as follows: 4.17%, 13.33%, 17.65% and 9.00%. The average growth rate is therefore 11.04%. [See Appendix 5c]
6) The Bond-Yield-Plus-Risk Premium approach is computed for using an estimate for the risk premium. This approach thus gives an estimated value for cost of equity. The estimated cost of equity of 14%. [See Appendix 6]
7) The final estimate for k is 14.67%. To arrive at this value, judgment by the management is often needed. When the values used using certain methods seem to be inferior or less important, less weight is given to it. However, in our case, it seems that all 3 methods used important data. Since the 3 methods gave similar answers anyway, we gave each method equal weight. [See Appendix 7]
8) As computed above using the DCF method, we were able to get the estimated cost of retained earnings which is 14.8%. However, to arrive at the estimate cost of new common stock, this value must be adjusted by the 30% flotation costs that were incurred. Therefore, ke = 16.85%. [See Appendix 8]
a. Since SIVMED's WACC is 11.78%, we get the retained earnings break point at $3,000,000 [See Appendix 9a]. Now to raise this amount of new capital, theoretically, SIVMED would have to use $900,000 of debt, $300,000 of preferred stock, and $1,800,000 of common stock. So to raise one dollar of new capital, SIVMED has to get $0.30 from debt, $0.10 from preferred, and $0.60 from new common stock. The MCC schedule is simply a plotted graph of WACC against dollars of new capital raised.
b. No. As more and more new capital is required in any year, the WACC would eventually begin to rise above 11.78%. The company will also have to find new buyers for its stocks, which would expect a higher rate of return, increasing the WACC. Also, extra large capital investment programs might increase the company's perceived riskiness as investors became increasingly concerned about management's ability to efficiently manage rapid growth.
c. $4,500,000 in depreciation cash flow would add to the $3,000,000 in retained earnings to get a total of $7,500,000. This would shift the MCC schedule to the right. Now because the MCC schedule has a major influence on the cost of capital that is used in capital budgeting analysis, the cost of capital used to evaluate projects may be reduced and this reduction could lead to the acceptance of more individual projects, and therefore, to a larger total capital budget.
10. The corporate cost of capital should be used by both divisions. However, adjustments for market risk, volatility and project’s peculiarities should be made. SIVMED's overall corporate cost of capital reflects the overall risk of the firm as perceived by its investors. Thus, the risks of the two divisions are combined. Now if the two divisions were operating as independent companies, their overall costs of capital would differ because of the significant risks they have. And so, SIVMED's overall cost of capital should be adjusted downward for the less risky division (Clinical Research Division) and upward for the more risky one (Genetic Engineering Division).
a. SIVMED’s weights: debt is at 31.9%, preferred stock is at 9.63% and common stock is at 51.06%. [See Appendix 11a]
b. SIVMED’s market value weights: debt is at 28.07%, preferred stock is at 9.63% and common stock is at 64.40%. [See Appendix 11b]
c. Since the percentage of the market values are closer to the target capital structure (28.07% to 30%, 8.04% to 10%, and 64.40% to 60%), it is better to use the market values weights.