Finance Project on Pepsi Co. - PowerPoint

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					Cost of Capital

         Chapter 11
     Learning Objectives
1.   Describe the concepts underlying the firm’s cost of
     capital (its weighted average cost of capital) and
     the purpose for its calculation.
2.   Calculate the after-tax cost of debt, preferred
     stock, and common equity.
3.   Calculate a firm’s weighted average cost of
     capital.
4.   Describe the procedure used by PepsiCo to
     estimate the cost of capital for a multidivisional
     firm.           Keown, Martin, Petty - Chapter 11    2
Learning Objectives
7.   Use the cost of capital to evaluate new
     investment opportunities.
8.   Compute the economic profit earned by the
     firm and use this quantity to calculate
     incentive-based compensation.
9.   Calculate equivalent interest rates for
     different countries.


                 Keown, Martin, Petty - Chapter 11   3
Slide Contents
1.   Principles Used in this Chapter
2.   Cost of Capital: Key Definitions and Concepts
3.   Computing the Cost of Individual Sources of Capital
4.   The Weighted Average Cost of Capital
5.   Calculating cost of capital for PepsiCo, Inc.
6.   Cost of Capital and New Investment
7.   Shareholder Value-Based Management
8.   Multinational Firms and Interest Rates

                   Keown, Martin, Petty - Chapter 11   4
1. Principles Used in this Chapter
    Principles Used in this Chapter
   Principle 1:
        The Risk-Return Trade-Off – We Won’t Take on Additional
         Risk Unless We Expect to Be Compensated with Additional
         Return.

   Principle 2:
        The Time Value of Money – A Dollar Received Today is Worth
         More Than a Dollar Received in the Future.

   Principle 3:
        Cash-Not Profits-Is King


                          Keown, Martin, Petty - Chapter 11           6
    Principles Used in this Chapter
   Principle 6 :
        Efficient Capital Markets – The Markets Are Quick and the
         Prices Are Right.
   Principle 7 :
        The Agency Problem –Managers Won’t Work for the Owner
         Unless It’s in Their Best Interest.
   Principle 8 :
        Taxes Bias Business Decisions.
   Principle 9 :
        All Risk Is Not Equal – Some Risk Can Be Diversified Away
         and Some Cannot.
                          Keown, Martin, Petty - Chapter 11          7
2. Cost of Capital: Key
Definitions and Concepts
Capital
   Capital represents the funds used to finance a
    firm's assets and operations. Capital
    constitutes all items on the right hand side of
    a balance sheet i.e. liabilities and common
    equity.

   Main sources: Debt, Preferred stock, Retained
    earnings and Common Stock


                  Keown, Martin, Petty - Chapter 11   9
Cost of Capital
   Cost of capital is the return/interest the
    investors/lenders require on their capital (for example,
    a corporation has to pay interest on bonds).
   Cost of capital can also be regarded as the hurdle rate
    that must be achieved by an investment before it will
    increase shareholder wealth.
   Cost of capital provides the basis for evaluating division
    or firm performance.


                     Keown, Martin, Petty - Chapter 11     10
Cost of Capital

Cost of Capital is also called:

     Hurdle rate for new investment
     Discount rate
     Opportunity cost of funds
     Required rate of return


                 Keown, Martin, Petty - Chapter 11   11
Investor’s Required Rate of Return

   Investor’s Required Rate of Return – the
    minimum rate of return necessary to attract
    an investor to purchase or hold a security.

   Investor’s required rate of return is not the
    same as cost of capital due to taxes and
    transaction costs.
       For example, a firm may pay 8% interest on debt
        but due to tax benefit on interest expense, the net
        cost to the firm will be lower than 8%.
                      Keown, Martin, Petty - Chapter 11   12
   Impact of transaction costs on cost of capital:
    For example, If a firm sells new stock for
    $50.00 a share and incurs $5 in flotation
    costs, and the investors have a required rate
    of return of 15%, what is the cost of capital?
   The firm has only $45.00 to invest after
    transaction cost.
      .15 x $50.00 = $7.5
    k= $7.5 / ($45.00)
    = .1667 or 16.67% (rather than 15%)
                    Keown, Martin, Petty - Chapter 11   13
Financial Policy
   A firm’s financial policy indicates the
    desired sources of financing and the
    particular mix in which it will be used.

   For example, a firm may choose to raise
    capital by issuing stocks and bonds in
    the ratio of 6:4 (60% stocks and 40%
    bonds).

                Keown, Martin, Petty - Chapter 11   14
Weighted Average Cost of Capital
(WACC)
   Combined costs of all the sources of
    financing used by the firm. The weighted
    average of the after-tax costs of each of
    the sources of capital used by a firm to
    finance a project where the weights
    reflect the proportion of total financing
    from each source.



                 Keown, Martin, Petty - Chapter 11   15
3. Computing the Cost of
Individual Sources of Capital

  Cost of Debt, Preferred stock and
           Common equity
The Cost of Debt

   The investor’s required rate of return on debt
    is simply the return that creditors demand on
    new borrowing.




                  Keown, Martin, Petty - Chapter 11   17
Cost of Debt
After tax cost of debt = kd(1-Tc)
= Before tax cost of capital less the effect
 of tax savings

Example: Debt at 9.75% and tax rate of 34%

   After-tax cost of debt = .0975(1-.34)
                              = 6.435%
                 Keown, Martin, Petty - Chapter 11   18
Cost of Preferred Stock
   Cost of Preferred Stock:
                       K ps = Dp/Pn
   Pn = net price (i.e. Issue price – Floatation costs)
   Dp = Preferred stock dividend per share

    Example: Determine the cost for a preferred stock
    that pays an annual dividend of $4.25, has a current
    stock price of $8.50 and incurs flotation costs of
    $1.375 per share.
        Cost = $4.25/(8.50 -1.375) = .074 or 7.44%

                     Keown, Martin, Petty - Chapter 11     19
Common Equity
   Sources:
       Retained earnings
       Sale of new shares

   There is no flotation cost on retained
    earnings.
   Retained earnings are not a free source of
    capital.

                     Keown, Martin, Petty - Chapter 11   20
Cost estimation challenges
   Cost of equity is more challenging to estimate
    than cost of debt or cost of preferred stock
    because common stockholder’s rate of return
    is not fixed. Furthermore, the costs will vary
    for two sources of equity (i.e. retained
    earnings and new issue).




                  Keown, Martin, Petty - Chapter 11   21
Cost estimation techniques
    Two commonly used methods for
     estimating common stockholder’s required
     rate of return are:
    1.   Dividend Growth Model
    2.   Capital Asset Pricing Model




                  Keown, Martin, Petty - Chapter 11   22
Dividend Growth Model

   Investors’ required rate of return (For
    Retained Earnings):
            Kcs = D1/Pcs+ g

   D1 = Dividends expected one year hence
   Pcs = Price of common stock
   g= growth rate
                 Keown, Martin, Petty - Chapter 11   23
Dividend Growth Model
   Investors’ required rate of return (For
    new issues)
            Kpcs = D1/NPcs + g

   D1 = Dividends expected one year hence
   Pcs = Net proceeds per share
   g= growth rate
                Keown, Martin, Petty - Chapter 11   24
Dividend Growth Model
 Example: A company expects dividends this year to be
 $2.20, based upon the fact that $2 were paid last year.
 The firm expects dividends to grow 10% next year and
 into the foreseeable future. Stock is trading at $50 a
 share.
     Cost of retained earnings:
     Kcs = D1/Pcs+ g
            2.20/50 + .10 = .144 or 14.4%
     Cost of new stock:
            Kncs = D1/NPcs                 +g
            2.20/(50-7.50) + .10 = .1518 or 15.18%
                   Keown, Martin, Petty - Chapter 11       25
Dividend Growth Model
   Dividend growth model is simple to use but
    suffers from the following drawbacks:

       It assumes a constant growth rate.

       The growth rate is then not easy to
        forecast.



                   Keown, Martin, Petty - Chapter 11   26
Capital Asset Pricing Model
     kc = krf + (km – krf)

Krf = Risk Free rate
 = Beta
km – krf = Market Risk Premium or
       Expected rate of return for
       “average security” minus the risk
       free rate, km – krf
               Keown, Martin, Petty - Chapter 11   27
Capital Asset Pricing Model

Example: If beta is 1.4, risk-free rate is
  3.75% and expected market rate is 12%

     kc = krf + B(km – krf)

          = .0375 + 1.4(.12 - .0375)
          = 15.3%
               Keown, Martin, Petty - Chapter 11   28
Capital Asset Pricing Model
Variable estimates
   CAPM is easy to apply. Also, the estimates for model
    variables are generally available from public sources.
   Risk Free Rate: Wide range of US government
    securities on which to base risk-free rate.
   Beta: Estimates of beta available from a wide range
    of services, or can be estimated using regression
    analysis of historical data.
   Market risk premium: It can be estimated by looking
    at history of stock returns and premium earned over
    risk-free rate.
                     Keown, Martin, Petty - Chapter 11       29
4. The Weighted Average Cost of
Capital
    Bringing it all together: WACC
   To estimate WACC, we need to know the
    capital structure mix and the cost of each of
    the sources of capital.
   For a firm with only two sources: debt and
    equity,
    WACC = (After tax cost of debt X proportion
    of debt financing) + (Cost of equity X
    proportion of equity financing)
                   Keown, Martin, Petty - Chapter 11   31
WACC Example
A firm borrows money at 7% after taxes
and pays 12% for equity. The company
raises capital in equal proportions –
50/50.

WACC = (.07 X .5) + (.12 X .5) = .095
                              or 9.5%

              Keown, Martin, Petty - Chapter 11   32
WACC: Summary




       Keown, Martin, Petty - Chapter 11   33
WACC example: Ash Inc.




         Keown, Martin, Petty - Chapter 11   34
Keown, Martin, Petty - Chapter 11   35
5. Calculating Cost of Capital
for PepsiCo, Inc.
PepsiCo

   PepsiCo calculated divisional cost of capital for
    each of its three major divisions: restaurants,
    food, and beverages.
   The target ratios for debt/equity mix and the
    pre-tax cost of debt were different for each
    division.



                   Keown, Martin, Petty - Chapter 11   37
   PepsiCo estimated the WACC for each
    division in a 3 step process:
       Estimate the cost of debt for each division
       Estimate the cost of equity for each
        division
       Estimate the WACC (with target capital
        structure for each division)


                   Keown, Martin, Petty - Chapter 11   38
Pepsi Co’s Cost of Debt
Division      Pretax            (1-tax rate)                  After-tax
              Cost of                                         cost of debt
              Debt
Rest          8.93%      X      0.62                      =   5.54%



Snack Foods   8.43%      X      0.62                      =   5.23%



Beverages     8.51%      X      0.62                      =   5.28%



                      Keown, Martin, Petty - Chapter 11                      39
Pepsi Co’s Cost of Equity
Division    Risk      Beta          (Exp. Mkt ret-        Cost of
            Free                    Risk free rate)       equity
            Rate
Rest        7.28%   X 1.17      X (11.48%-7.28%)        = 12.19%



Snack       7.28%   X 1.02      X (11.48%-7.28%)        = 11.56%
Foods

Beverages   7.28%   X 1.07      X (11.48%-7.28%)        = 11.77%



                    Keown, Martin, Petty - Chapter 11               40
Pepsi Co’s WACC
Division     Cost of              After-tax cost of             WACC
             Equity X             debt X the target
             Target               debt ratio
             Equity
             Ratio
Restaurant   (12.20%)       +     (5.54%)                   =   10.20%
             (0.70)               (0.30)


Snack        (11.56%)       +     (5.23%)                   =   10.29%
Foods        (0.80)               (0.20)


Beverages    (11.77%)       +     (5.28%)                   =   10.08%
             (0.74)               (0.26)


                        Keown, Martin, Petty - Chapter 11                41
6. Cost of Capital and New Investment
Cost of Capital and New Investment
   Cost of capital can serve as the discount rate
    in evaluating new investment when the
    projects offer the same risk as the firm as a
    whole.

   If risk differs, it is better to calculate a
    different cost of capital for each division.




                   Keown, Martin, Petty - Chapter 11   43
7. Shareholder
Value-Based Management
How much value has a firm
created for its owners?
   Compute the Market Value added (MVA). MVA
    measures the wealth created by a firm at a
    particular point in time.
   MVA = Total market value of the firm –
    Invested capital
       Market value of the Firm = Market value of the
        firm’s outstanding debt + market value of
        preferred stock + market value of the firm’s
        common stock

                     Keown, Martin, Petty - Chapter 11   45
How to evaluate performance
over a period of time?

   Compute Economic Profit (EP)
    = Accounting profit less a charge for
    use of capital
    = Net operating profit after tax (NOPAT)
    – invested capital X cost of capital



                Keown, Martin, Petty - Chapter 11   46
Kmart Example
EP = NOPAT – (Invested capital X cost of capital)

($568.979M) = 950M – ($19,727M X .0770)
Note: NOPAT represents a return of 4.82% while cost of
    capital is 7.70% leading to negative economic profit.

   As long as Kmart continues to earn a return on invested
    capital that is lower than its cost of capital, shareholder
    value declines.
   Kmart declared bankruptcy in Jan 2002
                       Keown, Martin, Petty - Chapter 11          47
How to increase Economic Profit?
Economic profits will increase if:
  (a) NOPAT increases without a corresponding
  increase in the cost of capital.
  (b) Firm invests in projects that earn more
  than the firm’s cost of capital.
  (c) Firm’s capital charge (cost of capital *
  invested capital) is reduced.

                 Keown, Martin, Petty - Chapter 11   48
    Economic Profit
Domtar Corp. increased NOPAT and economic profit by
identifying the following operating efficiencies:
   Cutting down on waste and damaged products.
   Operating machinery and equipment more efficiently.
   Improving product mix, devising methods to save on the
    purchase of raw materials.
   Improving health and safety performance, attracting and
    retaining new customers.
   Making better use of time in the office and the plant,
    implementing or improving preventative maintenance
    programs.
   Developing links with suppliers.
                       Keown, Martin, Petty - Chapter 11      49
 How to link Pay for Performance and
 Wealth Creation?

   Base manager’s incentive
    compensation on economic profit


                                                                 Actual
                                                               Economic
  Incentive        Base         % of Incentive
               =          X                               X   Profit/target
Compensation       Pay          Compensation
                                                               economic
                                                                 profit



                      Keown, Martin, Petty - Chapter 11                       50
Example: Base pay $100K/yr. + 30% incentive
compensation, with a target economic profit
$1M and an earned profit of $1.25M

  Incentive
Compensation
               = $100K X            .30             X   $1.2M/$1m



 Incentive Compensation = $37,500
 Total compensation
         = $100,000 + $37,500= $137,500
                    Keown, Martin, Petty - Chapter 11               51
8. Multinational Firms and
Interest Rates
Multinational Firms and
Interest Rates

   In an international setting, there can be
    different rates of inflation among different
    countries.
   The Fisher Model indicates that the nominal
    interest rate in the home or domestic country
    is a function of real interest rates and
    anticipated rate of inflation.


                   Keown, Martin, Petty - Chapter 11   53
Fisher Model and Domestic
Interest Rates
rn,h = (1 + r        r,h)(1   + ih) – 1

   rn,h = Nominal rate of interest at home
   r r,h = real interest rate at home
   Ih   =   inflation rate at home



Example: If real interest rate is 3% and inflation rate is
  5%, nominal rate will be 8.15%

                    (1.03)(1.05) – 1 = 8.15%
                          Keown, Martin, Petty - Chapter 11   54
International or Foreign Rates
and Fisher Effect

rn,h - rn,f = ih – if

Differences in observed nominal rates of
interest between two countries should
equal the difference in expected rates of
inflation between the two countries.


                    Keown, Martin, Petty - Chapter 11   55
Interest Rate Parity Theorem
1+r    n,h =   E1
1 + rn,f       E0
rn,h = Domestic one-period rate of interest
rn,f = Corresponding rate in foreign country
E0 & E1 = Exchange rates corresponding to current
   period (i.e. spot exchange rate) and one-period
   hence (i.e. the one-period exchange rate)
- Nominal interest rates are tied to exchange rates
- Differences in nominal interest rates are tied to
   expected rates of inflation
                    Keown, Martin, Petty - Chapter 11   56
Interest Rates and Currency
Exchange Rates
Example: If the domestic one-period
interest rate is 15.5%, and the
Japanese rate of interest is 5%, the
spot exchange rate is $1 to 1 yen
and the forward exchange rate is
$1.10 to 1 yen.

1 + .155 / 1 + .05 = 1.1/1= 1.10

             Keown, Martin, Petty - Chapter 11   57

				
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