Case 3 – Cost of Capital
The Cost of Capital for Master Tools
You have recently been hired by Master Tools (MT) in its relatively new treasury management department. MT was founded eight years ago by Martha Masters. Martha found a method to streamline the manufacturing process, resulting in a cheaper tool. The tools manufactured by MT are designed for the mass market and sold primarily through retail. The company is privately owned by Martha and her family, and it had sales of $97 million last year.
MT primarily sells to do-it-yourself (DIY) customers who use the tools for personal projects, although it does sell through various online marketplaces. As a result, the company’s sales are price sensitive. When the company had sufficient capital, it would expand production. Relatively little formal analysis has been used in its capital budgeting process. Martha has just read about capital budgeting techniques and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Martha would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company.
Martha wants you to use the pure play approach to estimate the cost of capital for MT, and she has chosen Snap-On Incorporated as a representative company. The following questions will lead you through the steps to calculate this estimate.
Assignment Directions
Write a case analysis of 1,000 – 1,500 words (4 to 5 pages), content (title page and reference page not included) in proper APA format, covering the following requirements:
1. Most publicly traded corporations are required to submit 10-Q (quarterly) and 10-K (annual) reports to the SEC detailing their financial operations over the previous quarter or year, respectively. These corporate filings are available on the SEC website [webpage]. Go to the SEC website and enter “SNA” for Snap-On in the “Search for Company Filings” link. Find the most recent 10-Q or 10-K and download the form. Look on the balance sheet to find the book value of debt and the book value of equity. If you look further down the report, you should find a section titled either “Long-Term Debt” or “Long-Term Debt and Interest Rate Risk Management” that will list a breakdown of Snap-On’s long-term debt. Discuss and analyze the items that you would find under long-term debt.
2. To estimate the cost of equity for Snap-On, go to finance.yahoo.com and enter the ticker symbol SNA. Follow the various links to find answers to the following questions: What is the most recent stock price listed for Snap-On? What is the market value of equity, or market capitalization? How many shares of stock does Snap-On have outstanding? What is the beta for Snap-On? Now go back to finance.yahoo.com and follow the “Bonds” link. What is the yield on three-month Treasury bills? Using a 7 percent market risk premium, what is the cost of equity for Snap-On using the CAPM? Discuss and analyze your answer.
3. Go to Reuters [webpage] and find the list of competitors in the industry. Find the beta for each of these competitors, and then calculate the industry average beta. Using the industry average beta, what is the cost of equity? Discuss and analyze whether you use the beta for Snap-On or the beta for the industry in this case?
4. You now need to calculate the cost of debt for Snap-On. Go to FINRA [webpage], enter Snap-On as the company, and find the yield to maturity for each of Snap-On’s bonds. What is the weighted average cost of debt for Snap-On using the book value weights and the market value weights? Discuss and analyze if it makes a difference in this case if you use book value weights or market value weights?
5. You now have all the necessary information to calculate the weighted average cost of capital for Snap-On. Calculate the weighted average cost of capital for Snap-On using book value weights and market value weights, assuming Snap-On has a 21 percent tax rate. Discuss and analyze which cost of capital number is more relevant and why?
6. You used Snap-On as a representative company to estimate the cost of capital for MT. What are some of the potential problems with this approach in this situation? Discuss and analyze what improvements you might suggest.
Submission Guidelines
- Prepare this Assignment according to the APA guidelines, including a title page, an introduction, and a conclusion. An abstract is not required. Use in-text citations and include a References section. A template is included in the Resources and Supports.
- In your report, make certain that you include at least three (3) credible outside references
The influence of cost of debt, cost of equity and weighted average cost of capital on dividend policy decision: evidence from non-financial companies listed on the Frankfurt Stock Exchange. (2024). Future Business Journal, 10(1), 99. https://doi.org/10.1186/s43093-024-00384-8
Priem, R., & Gabellone, A. (2024). The impact of a firm’s ESG score on its cost of capital: can a high ESG score serve as a substitute for a weaker legal environment. Sustainability Accounting, Management and Policy Journal, 15(3), 676-703. https://doi.org/10.1108/SAMPJ-05-2023-0254
Baker, M., & Wurgler, J. (2015). Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation, Capital Structure, and the Low-Risk Anomaly. The American Economic Review, 105(5), 315-320. https://doi.org/10.1257/aer.p20151092
Capital Market Structure
Welcome to Week 6, where we will focus on capital market structure in a perfect market, leverage, arbitrage, firm value, and follow through to a company’s payout policy, aligned to the Modigliani and Miller (MM) principle, as well as integrating the concepts learned over the past weeks on risk, return, and structure. The course objectives include
- analyzing the influence of taxes on the choice of capital structure
- examining how companies decide on dividend payouts and their implications
- continuing to explore the capital asset pricing model
- distinguishing between operating leverage and financial leverage
- evaluating the effects of risk and return as it relates to the cost of capital and capital budgeting decisions
- integrating portfolio theory and capital asset pricing model
Calculating Acceptable Debt and Equity
When talking about capital structure, a company is determining the acceptable amount of debt and equity for the business. How does a company accomplish this? By maximizing the total value of the securities issued for the company.
Pie Theory
The first theory presented is the Pie Theory:
V= B+S, where
- B is the market value of the debt,
- S is the market value of equity.
MM Theory
Another theory widely accepted by the finance world is perfect capital markets, developed by Modigliani and Miller and referred to as the MM theory. Three conditions that make capital markets perfect include
- trading the same set of securities at competitive market prices, equal to the present value of their future cash flows
- there are no taxes, transaction costs, or issuance costs associated with security trading
- financing decisions do not change the cash flows generated by the company’s investments, nor do they reveal new information about them (Berk & DeMarzo, 2017).