Assume that you have just been charged with the responsibility for evaluating the divisional cost of capital for each of the business segments.

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Barry Stewart Murphy
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1 PROBLEM SET: Cost of Capital Exercise 1. BUD [10] In 2006, Annheuser-Busch Companies Inc. (BUD), engaged in the production and distribution of beer worldwide, operates through four business segments: Domestic Beer, International Beer, Packaging, and Entertainment. The Domestic Beer segment offers beer under Budweiser, Michelob, Bush, and Natural brands in the United States, in addition to a number of specialty beers including non-alcohol brews, malt liquors, and specialty malt beverages, as well as energy drinks. The International Beer segment markets and sells Budweiser and other brands outside the United States and operates breweries in the United Kingdom and China. In addition, the International Beer segment markets and administers license and contract brewing agreements with various foreign brewers. The packaging segment manufactures beverage cans and can lids for drink customers, buys and sells used aluminum beverage container, and recycles aluminum containers. Finally, the Entertainment segment owns and operates theme parks. In 2005, Anheuser-Busch reported the following segment revenues and net income: Domestic International Beer Beer Packaging Entertainment Gross sales 10, , Income before income taxes 2, Equity income 147 Net Income (Numbers for 2005, $ millions) Assume that you have just been charged with the responsibility for evaluating the divisional cost of capital for each of the business segments. 1. Outline the general approach you would take in evaluating the cost of capital for each of the business segments. 2. Should the fact that $1,156 million of the Packaging segment s revenues come from internal sales to other Bush segments affect your analysis? If so, how? Exercise 2. Smaltz [10] Smaltz Enterprises is currently involved in its annual review of the firm s cost of capital. Historically, the firm has relied on the CAPM to estimate its cost of equity capital. The firm estimates that its equity beta is 1.25, and the current yield on long-term U.S. Treasury bonds is 4.28%. The firm s CFO is currently in a debate with one of the firm s advisers at its investment bank about the level of the equity risk premium. Historically, Smaltz has used 7% to approximate the equity risk premium. However, the investment banker argues that this premium has shrunk dramatically in recent years and is more likely to be in the 3% - to - 4% range. 1. Estimate Smaltz cost of equity capital using a market risk premium of 3.5%. 2. Smaltz s capital structure is composed of 75% equity (based on current market prices) and 25% debt on which the firm pays a yield of 5.125% before taxes at 25%. What is the firm s WACC? Exercise 3. Filer [10] Filer Manufacturing has 9.5 million shares of equity outstanding. The current share price is 53, and the book value per share is 5. Filer Manufacturing also has two bond issues outstanding. The first bond issue has a face value of 75 million and an 8% coupon, and sells for 93% of par. The second issue has a face value of 60 million and a 7.5% coupon, and sells for 96.5% of par. The first issue mature in 10 years, the second in 6 years. 1

2 1. What are Filer s capital structure weights on a book value basis? 2. What are Filer s capital structure weights on a market value basis? 3. Which are more relevant, the book or market value weights? Why? Exercise 4. Cost of Debt [5] How do you determine the appropriate cost of debt for a company? Does it make a difference if the company s debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors? Exercise 5. CBF [15] Caliber s Burgers and Fries is a rapidly expanding chain of fast-food restaurants, and the firm s management wants to estimate the cost of equity for the firm. As a first approximation, the firm plans to use the beta coefficient of McDonald s Corp. (MCD), which equals 0.56, as a proxy for its beta. In addition, Caliber s financial analyst looked up the current yield on 10-year U.S. Treasury bonds and found that it was 4.2%. The final piece of information needed to estimate the cost of equity using the capital asset pricing model is the market risk premium, which is estimated to be 5%. 1. Using this information, estimate the cost of equity for McDonald s. 2. McDonald s Corp. has an enterprise value of about $80 billion and a debt of $15 billion. If Caliber s has no debt financing, what is your estimate of the firm s beta coefficient? You can assume that McDonald s debt has a beta of 0.2. Exercise 6. Divisional Cost of Capital [15] Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC were used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division s cost of capital? Exercise 7. Calculating a firm s WACC and project WACC. [15] Amgel Manufacturing Company s current capital structure is composed of 30% debt and 70% equity (based on market values). Amgel s equity beta (based on its current level of debt financing) is 1.20, and its debt beta is Also, the risk-free rate of interest is currently 4.5% on long-term government bonds. Amgel s investment banker advised the firm that, according to her estimates, the market risk premium is 5.25%. 1. What is your estimate of the cost of equity capital for Amgel (based on the CAPM)? 2. If Amgel s marginal tax rate is 35%, what is the firm s overall weighted average cost of capital (WACC)? 3. Amgel is considering a major expansion of its current business operations. The firm s investment banker estimates that Amgel will be able to borrow up to 40% of the needed funds and maintain its current credit rating and borrowing costs. Estimate the WACC for the project. Exercise 8. You want to estimate the cost of equity for IBM (International Business Machines). From Damodaran s webcite you can download: Beta estimate (eg. regression estimate) Estimate of risk premium (e.g. geometric avg ) Go to the Federal Reserve for current interest rate numbers 2

3 1. What is the current cost of equity capital for IBM? Exercise 9. You want to estimate an industry cost of capital for a given set of firms. You have collected data on three companies, have estimated the equity beta β S for each of them, and found the debt/equity ratio (B/S) for each of the firms. You also estimate Tax rate: 35% Risk free return: 3% Market risk-premium: 5% Comparables β S B/S Comp # Comp # Comp # What additional information is needed about the debt to evaluate the average unlevered equity beta? 2. Suppose all of these three firms have risk free debt. Calculate the unlevered beta for each firm, and an estimate of the industry unlevered beta. Exercise 10. Consider the following data for US department stores in mid-2009, showing the equity beta, ratio of net debt to enterprise value, (D/V ), and debt rating for each firm. Company ticker Equity beta D/V Debt Rating Dillard s DDS B J.C.Penney Company JCP BB Kohl s KSS BBB Macy s M BB Nordstrom JWN BBB Saks SKS CCC Sears Holding SHLD BB You also have the following information about typical beta values for debt. Debt Betas by Rating and Maturity By Rating A and above BBB BB B CCC Avg Beta < By Maturity (BBB and above) 1-5 year 5-10 year year > 15 year Avg Beta Estimate the average and median asset beta for the industry. 3

4 Empirical Solutions PROBLEM SET: Cost of Capital Exercise 1. BUD [10] 1. Use data for comparable firms in the different industries, estimate asset betas for each industry, to find estimates of cost of capital for each industry. 2. The risk is closer to the risk of the beer divisions than a general firm in the packaging industry, since the demand from packaging from beer division very important for packaging division. (1156/1831 = 63% of total sales) Exercise 2. Smaltz [10] r E = = 8.65% W ACC = (1 0.25) = 7.45% Exercise 3. Filer [10] Book value equity: = 47.5 million. Book value debt = 135 million Book value: Equity weight: 26% Bond weight: 74% Market value equity = million. Market value debt = = million Firm market value = = million Bond weight = 20.2% 20% Equity weight = 79.8% 80% Market value is the most relevant for valuation purposes. Exercise 4. Cost of Debt [5] Publicly traded: From the market prices of the company s securities, what is the implicit interest rate? Privately placed: Firm rating, debt fraction, comparable listed firms are all potential inputs to the estimation. Exercise 5. CBF [15] cost of capital r Mc = = = = 6.66% 4

5 Exercise 6. Divisional Cost of Capital [15] When the divisions are very different in nature, with different risks. The risky divisions would get most projects, since they will be investing in some negative NPV projects due to the too low cost of capital. Problems due to lack of information Possible solutions Comparable firms Accounting betas for each division Exercise 7. Calculating a firm s WACC and project WACC. [15] 1. Calculating cost of equity r E = = 10.8% 2. WACC Without considering tax Factoring in tax 3. Project WACC using the 40% Debt ratio. Exercise 8. From Damodarans webcite download: Beta estimate 0.73 Historical risk premium (geom.avg ): 6.03% Federal reserve: r D = = 6.02% r = % % = 9.37% W ACC = (1 0.35) % % = 8.74% W ACC = (1 0.35) % % = 8.045% Any number of interest rate figures, choice based on the horizon the calculation is done over Discount window primary credit U.S. government securities Treasury bills (secondary market) week month month year 0.25 Treasury constant maturities Nominal 11 1-month month month year

6 2-year year year year year year year 3.60 For example, with a five year horizon we d take the constant maturity interest rate of 1.39%, and calculate the figure for IBM as r it = r ft + β it (r m r f ) = = = 5.79% Exercise Need information about risk of bonds. Here we have no info, so to get anywhere assume the debt is risk free. 2. Equity betas are unlevered using (i.e., assuming that debt is risk-free): [ ] S β U = β S S + (1 T C )B Exercise 10. Comparables β S B/S β U Comp # Comp # Comp # Average unlevered beta 0.82 Unlevered cost of equity r U = (5.0) = 7.1% Note that D/V provides the fraction of debt financing, and 1 D/V the fraction of equity financing, for each firm. Using the data for debt betas we can use the releationship β U = E E + D β E + D D + E β D Company ticker Equity beta D/V Debt Rating Debt beta Asset Beta Dillard s DDS B J.C.Penney Company JCP BB Kohl s KSS BBB Macy s M BB Nordstrom JWN BBB Saks SKS CCC Sears Holding SHLD BB Average 1.16 Median

Cost of Capital. Cost of capital A firm s cost of capital is the required return on its investments.

Cost of Capital. Cost of capital A firm s cost of capital is the required return on its investments. Cost of Capital Cost of capital A firm s cost of capital is the required return on its investments. For capital budgeting purposes, need a cost of capital, the required return on the firm s investments.