Problem 4.4
4.4 Three-Step Process for Estimating a Firms WACC
Compano Inc. was founded in 1986 in Baytown, Texas. The firm provides oil-field services to the Texas Gulf Coast region, including the leasing of drilling barges. Its balance sheet for year-end 2006 describes a firm with $830, 541,000 in assets (book values) and invested capital of more than $1.334 billion (based on market values):
December 31, 2006
Balance Sheet Invested Capital
Liabilities and OwnersCapital (Book Values) (Market Values)
Current liabilities
Accounts payable $ 8,250,000
Notes payable – –
Other current liabilities $ 7,266,000
Total current liabilities $ 15,516,000 $ –
Long-term debt (8.5% interest paid
Semiannually, due in 2015) $ 420,000,000 $ 434,091,171
Total liabilities $ 435,516,000 $ 434,091,171
Owners capital
Common stock ( $1 par value per share ) $ 40,000,000
Paid-in-capital 100,025,000
Accumulated earnings 255,000,000
Total owners capital $ 395,025,000 $ 900,000,000
Total liabilities and owners capital $ 830,541,000 $ 1,334,091,171
Companos executive management team is concerned that its new investments be required to meet an appropriate cost of capital hurdle before capital is committed.
Consequently, the firms CFO has initiated a cost of capital study by one of his senior financial analysts, Jim Tipolli. Jims first action was to contact the firms investment banker to get input on current capital costs.
Jim learned that although the firms current debt capital required an 8.5% coupon rate of interest (with annual interest payments and no principal repayments until 2015), the current yield on similar debt had declined to 8% if the firm were to raise debt funds today. When he asked about the beta for Companos debt, Jim was told that it was standard practice to assume a beta of .30 for the corporate debt of firms such as Compano.
What are Companos total invested capital structure weights for debt and equity?
Based on Companos corporate income tax rate of 40%, the firms current capital structure, and an unlevered beta estimate of .90, what is Companos levered equity beta?
Assuming a long-tern U.S. Treasury bond yield of 5.42% and an estimated market risk premium of 5%, what should Jims estimate of Companos cost of equity be if he uses the CAPM?
What is your estimate of Companos WACC?
Problem 5.5
5.5 Divisional WACC
In 2006, Anheuser-Busch Companies Inc. (BUD), engaged in the production an distribution of beer worldwide, operating through four business segments: Domestic Beer, International Beer, Packaging, and Entertainment. The Domestic Beer segment offers beer under Budweiser, Michelob, Busch, 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 negotiates 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 containers, 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.
($ millions) Domestic Beer International Beer Packaging Entertainment
2005
Gross sales $ 10,121.00 $ 864.00 $ 1, 831.50 $ 904.40
Income before 2,293.40 70.10 120.40 215.10
income taxes
Equity income – 147.10 – –
Net income $ 1,421.90 $433.70 $74.60 $133.40
Assume that you have been charged with the responsibility for evaluating the divisional cost of capital for each of the business segments.
Outline the general approach you would take in evaluating the cost of capital for each of the business segments.
Should the fact that $1,156 million of the Packaging segments revenues come from internal sales to other Busch segments affect your analysis? If so, how?
Given
December 31, 2006
Liabilities and Owner’s Capital
Balance Sheet
(Book Values)
Invested Capital
(Market Values)
Current liabilities
Solution Legend
Accounts payable
$ 8,250,000
= Value given in problem
Notes payable
40,000,000
40,000,000
= Formula/Calculation/Analysis required
Other current liabilities`
7,266,000
= Qualitative analysis or Short answer required
Total current liabilities
$ 55,516,000
$ 40,000,000
= Goal Seek or Solver cell
= Crystal Ball Input
Long-term debt (8.5% interest paid
semi-annually, due in 2015)
$ 420,000,000
$ 434,091,171
= Crystal Ball Output
Total liabilities
$ 475,516,000
$ 474,091,171
Owners’ capital
Common stock ($1 par value per share)
$ 40,000,000
Paid-in-capital
100,025,000
Accumulated earnings
255,000,000
Total owners’ capital
$ 395,025,000
$ 900,000,000
Total liabilities and owners’ capital
$ 870,541,000
$ 1,374,091,171
Capital Market Data
Treasury Bond Yield
5.42%
Market Risk Premium
5.00%
Unlevered equity beta (SIC 4924)
0.90
Stock price
$ 22.50
Market capitalization
Yield on debt
8.00%
Bond beta
0.30
Short-term interest bearing debt
New long-term debt total
$ 434,091,171
Tax Rate
40.00%
Solution
Step 1: Evaluate the capital structure weights
Enterprise Value = Market Capitalization + Debt
Debt / Enterprise Value
Equity / Enterprise Value
Step 2: Estimate the costs of Financing
Debt (after taxes)
Equity
Levered equity beta
Step 3: Calculate the WACC
WACC
Capital Structure Weight
Source of Capital
(Proportion)
After-Tax Cost
Weighted After-Tax Cost
Debt
Equity
WACC
A. In order to evaluate the cost of capital for each of Anheuser-Busch Companies, Inc’s business segments, the cost of equity and after-tax cost of debt must be first established.
In order to do so, the capital structure for each of the business segments must be established. For the cost of equity, using CAPM, the risk free rates, betas and market risk premiums for each segments need to be identified. Below are suggestions for some of the basis that can be sued to establish these factors.
Segment Risk Free Rate Beta Market Risk Premium
Domestic Beer Fed 90-day T-bill Relative to the local beer market S&P 500 earnings yield
International Beer UK 90-day T-bill Relative to the international beer market with focus on China and UK Global index
Packaging Fed 90-day T-bill Relative to the local packaging industry S&P 500 earnings yield
Entertainment Fed 90-day T-bill Relative to the local entertainment industry S&P 500 earnings yield
After establishing the basis of evaluating cost of equity for each segment, the after-tax cost of debt is next. The income taxes for each of the segment must be identified, and the market prices of divisional debts will help determine yield-to-maturities.
After which the cost of capital can now be evaluated.
B. Yes, the internal sales definitely affect the analysis because of its percentage relative to the division’s total sales. For example, in identifying the beta for the Packaging Division, the fact that it is not an average player in the industry must be taken into account when ‘relative to the local industry’ is evaluated.
