This mini case study was adapted from the Corporate Finance: Core Principles and Applications, 5th Ed. by S. Ross,R. Westerfield, J. Jaffe, and B. Jordan, published by McGraw-Hill Higher Education. This case is used for instruction purpose only.
The Cost of Capital for Nature Beauty
You have recently been hired by Nature Beauty Company, in its relatively new treasury management department. Nature Beauty was founded five years ago by Elizabeth Taylor.
Elizabeth found a method to producehigh quality shampoo using natural ingredients. The shampoo produced by Nature Beauty is in a good position to compete with other more established shampoo producers. The company is privately owned by Elizabeth Taylor and her family, and it had sales of $12 million last year.
Nature Beauty primarily sells its products through a wholesaler who distributes the products through its network of retailers throughout the country.
Nature Beauty's growth to date has come from its innovation, quality, and low costs. When the company had sufficient capital, it would expand production.
Relatively little formal analysis has been used in its capital budgeting process. Elizabeth 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 Elizabeth 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.
Elizabeth wants you to use a similar company to estimate the cost of capital (WACC) for Nature Beauty, and she has chosen Procter & Gamble as a representative company.
The following questions will lead you through the steps to calculate this estimate.
1. Most publicly traded corporations are required to submit 10Q (quarterly) and 10K (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. Go to the SEC website and enter "PG" for Procter & Gamble in the "Search for Company Filings" link and search for SEC filings made by Procter & Gamble. Find the most recent 10Q or 10K 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 Procter & Gamble's long-term debt.
2. To estimate the cost of equity for Procter & Gamble, go to finance yahoo and enter the ticker symbol "PG." Follow the various links at this website to find answers to the following questions:
a) What is the most recent stock price (and provide the associated date) listed for Procter & Gamble?
b) What is the market value of equity, or market capitalization?
c) How many shares of stock does Procter & Gamble have outstanding?
d) What is the beta for Procter & Gamble?
e) Now go back to finance yahoo 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 Procter & Gamble using the CAPM?
3. Go to reuters and find the list of competitors in the industry. You can do this by clicking on the search symbol, then enter "Procter & Gamble". The list of competitorsis available when you click on "Overview" in the horizontal menu. Use U.S.-based competing companies for this task.
a) Find the beta for each of these competitors, and then calculate the industry average beta.
b) Using the industry average beta, what is the cost of equity?
c) Does it matter if you use the beta for Procter & Gamble or the beta for the industry in this case?
4. You now need to calculate the cost of debt for Procter & Gamble. Under Market Data Center Bonds Guide, choose "search" then enter "Procter & Gamble" as the company, and find the yield to maturity for each of Procter & Gamble's bonds.
a) What are the weighted average costs of debt for Procter & Gamble using the book value weights first and then the market value weights?
b) Does it make 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 Procter & Gamble.
a) Calculate the weighted average cost of capital for Procter & Gamble using book value weights and market value weights, assuming Procter & Gamble has a 35 percent marginal tax rate.
b) Which cost of capital number is more relevant?
6. You used Procter & Gamble as a representative company to estimate the cost of capital for Nature Beauty.
a) What are some of the potential problems with this approach in this situation?
b) What improvements might you suggest?