E
Case 54
US
Ace Repair, Inc.
Cost of Capital
G
Directed
IN
N
R
A
E
In 1978, while he was taking a course on entrepreneurship as a business student at a large state uni-L
versity, Peter Vanderhein wrote a term paper on the management of auto repair shops. Peters uncle owned a repair shop, and Peter had worked for him as well as for several other body shops E
when he was in high school and college. Once he began taking business courses, Peter came to rec-G
ognize that most shops were inefficient, especially in the way they managed their inventories and receivables. This inefficiency resulted in excessive stocks of some items, shortages of others, fre A
–
quent stock-outs, late payments, bad debt losses, and many dissatisfied customers. Still, in spite of G
their inefficiency, the average repair shop appeared to be fairly profitable. Peter concluded that an N
opportunity existed to buy inefficient auto repair shops, consolidate them into a concern that was R SALE OR CLASSROOM
large enough to use computers to manage inventories and receivables, and thereby increase prof E
–
itability sharply. He also felt that volume discounts, improved training, and other economies of scale, C
would give a further boost to profits.
With encouragement from his family and professors, Vanderhein decided to put his theory to F
the test, and in 1979 he started Ace Repair, Inc. Ed Adams, Peters uncle, wanted to retire, and he agreed to sell out subject to a purchase money mortgage which would be repaid from the busi O
–
ness cash flow. Peter was also able to borrow $100,000 from some family friends, and he arranged Y
a $50,000 bank loan secured by the business assets. He used this $150,000 to purchase computers T
and software, and to train his employees in the use of the new equipment.
Adams agreed to help Peter set things up and then help the shops employees adapt to the R
new procedures. Everything went well, and profits rose even more rapidly than under Peters opti-E
mistic forecasts. By early 1981, Peter felt that the bugs were out of his shop management system, so P
with Eds help, he began to look seriously for additional acquisitions. He took over two new shops later in 1981, sending employees from the fi O
rst shop to help run the new ones. The operations of the acquired shops were as successful as those of the first shop. He bought three additional shops in 1982, R
ONLY NOT FO
and acquisitions continued at an increasing pace thereafter. By 1995, Ace Repair controlled a total P
of 243 shops located throughout the Midwest.
Peter used a mix of securitiescommon stock, preferred stock, and first mortgage bondsin addition to retained earnings to finance acquisitions and open de novo shops, while using trade credit plus bank loans to help meet working capital needs. Peter has also considered the use of convertible securities, but to date no convertibles have been issued. Currently, Ace has 6.2261 million com-Copyright © 1994. The Dryden Press. All rights reserved.
FOR REVIEW
© 1997 South-Western, a part of Cengage Learning E
mon shares outstanding, of which Peter owns 17 percent. The stock sells in the over-the-counter market for $30.50 per share.
Since the companys inception, Peter has been directly and tirelessly involved in all facets of US
the business. He is satisfied with the service his shops provide, with the companys inventory and receivables management, and with the marketing aspects of the business. However, he has become increasingly uneasy about the finance function, in which he has no special expertise. The controller has overseen most financial matters, but with the rapid growth in the scope and size of the business, financial decisions have become increasingly complex. Further, competition from large cor-
porations such as Sears, Wal-Mart, and auto dealerships has been increasing. So, by 1995, G
Vanderhein concluded that to ensure continued success, he must establish a finance group that was as competent and sophisticated as those of his competitors. Therefore, in late 1995, he hired Adam IN
Naranjo, a senior financial executive with a major retail chain, as vice president and chief financial officer (CFO).
N
Naranjo began by reviewing the existing capital investment procedures. After going over the R
procedures manuals and the supporting analyses for recent capital investment decisions, he concluded that the overall procedures were generally appropriate: The firm relied on discounted cash A
flow criteria to arrive at accept/reject decisions for most projects; it estimated future cash flows on E
an incremental basis; and it discounted cash flows at the firms weighted average cost of capital (WACC). However, the estimate of the cost of capital itself was questionable.
L
In the most recent capital budgeting exercise, at year-end 1995, the controller used a before-E
tax debt cost of 10 percent, which was equal to the coupon rate on Aces last (1993) long-term first G
mortgage bond issue. These bonds are rated single A, will mature in 17 years, and can be called in 3 years. For the cost of equity, the controller used the year-end earnings yield (E/P) of 7.5 percent, A
based on an earnings per share of $2.30 and a share price of $30.50. His justification for using the G
E/P yield was that since investors were getting $2.30 of earnings for a $30.50 investment, they were willing to accept a 7.5 percent rate of return on their money. Also, the controller noted that if N R SALE OR CLASSROOM
the company could sell stock for $30.50 per share and then invest the proceeds at a 7.5 percent rate E
of return, earnings per share would remain at $2.30. He also noted that this 7.5 percent is an after-tax C
cost, and it is below the after-tax cost of debt. Of course, the controller wants the company to sell
stock only to finance projects that will earn more than the 7.5 percent cost of equity, hence will F
increase earnings per share. Table 4 (2) contains the quotation of the companys preferred stock. This security has a par value of $100 and new issues would have a flotation cost of $2.50 per share.
O
Given estimates of the capital components costs, the controller calculated the WACC on the Y
basis of weights as determined from the balance sheet shown in Table 2. These book value weights differ from the market value weights and from the companys target capital structure as reported in T
Table 4, part 11.
R
In early January 1996, Naranjo decided to hire your consulting firm to conduct a cost of cap-E
ital analysis and to make a critical evaluation of the current estimation procedures. Naranjo provided P
you with the financial statements given in Tables 1 and 2, plus the information in Tables 3 and 4.
You must critique Aces current procedures for estimating the costs of debt and equity, and O
then use the data to estimate Aces component costs of capital, WACC, and marginal cost of capi-R
ONLY NOT FO
tal schedule. You must also decide whether to use your estimate of the marginal weighted average P
cost of capital as the hurdle/discount rate for all of the firms projects.
Naranjo is also interested in your views on the weights used to calculate the WACC. The controller has been using book weights based on the actual capital structure, but considering long-term capital only. His reasoning was that this is the way the capital used for capital budgeting purposes has actually been raised, and also that Moodys, S&P, and all security analysts whose reports he has seen focus on actual capital structures based on actual accounting statements. He chose not to use market value weights in part because investors apparently do not focus on market value weights, and also because market value weights would be unstable, hence would result in a fluctuating WACC, and as a result would destabilize the capital budgeting process. He has toyed with the idea of using the FOR REVIEW
© 1997 South-Western, a part of Cengage Learning E
target capital structure weights, but he correctly pointed out that the targets have never been attained, and there is no reason to expect them to be attained anytime soon. Naranjo wants your opinion on (1) what weights should be used, and (2) how much difference the choice of weights would make in US
the calculated WACC.
If Naranjo likes your reportif he thinks it is logical, technically correct, and well presented
he will hire your firm for other consulting assignments and recommend you to his friends. He might even offer you the job as treasurer of Ace Repair. In any event, a well-received report will give your career a big boost, so you want to do a good job. To help structure your analysis and report,
answer the following questions.
G
IN
QUESTIONS
N
R
1. a. Discuss the specific items of capital that should be included in the WACC.
b. The comptroller currently finds the weights for the weighted average cost of capital A
(WACC) from information from the balance sheet shown in Table 2. Compute the book E
value weights that the comptroller currently uses for the companys capital structure.
c. Based on the suggestion that the focus should be on market values, compute the weights L
of debt, preferred stock, and common stock. E
d. Are book value or market value weights better for calculating the firms weighted aver-G
age cost of capital?
A
2. a. Critique Ace Repairs current method of estimating its before-tax cost of debt.
G
b. Is the earnings yield (E/P) an appropriate measure of the firms cost of equity?
N R SALE OR CLASSROOM
3. a. What is the best estimate of Aces cost of debt?
E
b. Should flotation costs be included in the component cost of debt calculation? Explain.
C
c. Should the nominal cost of debt or the effective annual rate be used? Explain.
d. How valid is an estimate of the cost of debt based on the yield to maturity of Aces debt F
(ignore the call provision in 3 years) if the firm plans to issue 20-year long-term debt?
e. What other methods could be used to estimate the cost of debt if, for example, Aces out-O
standing debt had not been traded recently?
Y
4. a. What is Aces cost of preferred stock?
T
b. Aces preferred stock is more risky to investors than its debt, yet the before-tax yield on R
its preferred is lower than the yield on A-rated debt issues. Why does this occur?
E
c. What if Aces preferred stock required the establishment of a sinking fund that calls for P
the retiring 5 percent of the initial issue of preferred stock each year at par? How would the cost of preferred stock change and be handled in the WACC calculation?
O
R
ONLY NOT FO
5. a. Why is there a cost associated with retained earnings?
P
b. What is Aces cost of retained earnings, based on the CAPM approach and the analysts
long run forecast rate of growth?
c. Why might one consider the T-bond rate to be a better estimate of the risk-free rate than the T-bill rate? Why might one argue for the use of the T-bill rate?
d. How do historical betas, adjusted historical betas, and fundamental betas differ? Would Aces historical beta be a better or a worse measure of its future market risk than the historical beta for a portfolio would be for the portfolios future market risk? Explain.
FOR REVIEW
© 1997 South-Western, a part of Cengage Learning E
e. What are some alternative ways to obtain a market risk premium for use in a CAPM cost-of-equity calculation? Discuss both the possibility of obtaining estimates from outside organizations and also ways which Ace could calculate a market risk premium itself. US
6. a. What is Aces discounted cash flow (DCF) cost of retained earnings?
b. Suppose Ace, over the last few years, has had an 18 percent average return on equity (ROE) and has paid out 20 percent of its net income as dividends. Under what conditions could this information be used to help estimate the firms expected future growth rate, g?
Estimate ks using this procedure for determining g.
G
c. What was the firms historical dividend growth rate using the point-to-point method?
Using the linear regression method?
IN
7. Use the bond-yield-plus-risk-premium method to estimate Aces cost of retained earnings.
N
R
8. Based on all the information available, what is your best estimate for ks? Explain how you decided what weight to give to each estimating technique.
A
E
9. What is your estimate of Aces cost of new common stock, ke? What are some potential weaknesses in the procedures used to obtain this estimate?
L
E
10. a. Compute Aces WACCs based on the companys target capital structure and construct G
the marginal cost of capital (MCC) schedule. How large could the companys capital budget be before it is forced to sell new common stock? Ignore depreciation at this point.
A
b. Would the MCC schedule remain constant beyond the retained earnings break point, no G
matter how much new capital it raised? Explain. Again, ignore depreciation.
c. How does depreciation affect the MCC schedule? If depreciation were simply ignored, N R SALE OR CLASSROOM
would this affect the acceptability of proposed capital projects? Explain.
E
C
11. Should the corporate cost of capital as developed above be used for all projects? If not, what
type of adjustments should be made?
F
O
Y
T
R
E
P
O
R
P
ONLY NOT FO
FOR REVIEW
© 1997 South-Western, a part of Cengage Learning E
TABLE 1
Ace Repair, Inc.: Income Statement
for the Year Ended December 31, 1995
US
(In Thousands of Dollars)
Net sales
$400,467
Cost of goods sold
$320,477
Gross profit
$ 79,990G
Admin and selling exp
$ 34,040
Depreciation
$ 4,080
IN
Miscellaneous expenses
$ 10,132
N
Total operating exp
$ 48,252
EBIT
$ 31,738
R
Interest on ST loans
$ 3,016
A
Interest on LT debt
$ 3,600
E
Total interest
$ 6,616
Before-tax earnings
$ 25,122
L
Taxes (40%)
$ 10,049
E
Earnings bef. pref. div.
$ 15,073
Preferred dividends
$ 800
