Calculating 3M's Cost of Capital
Described how to estimate a company's WACC, which is the weighted average of its costs of debt, preferred stock, and common equity. Most of the data we need to do this can be found in Thomson One. Here, we walk through the steps used to calculate Minnesota Mining & Manufacturing's (MMM) WACC.
Discussion Questions
1. As a first step we need to estimate what percentage of MMM's capital comes from long-term debt, preferred stock, and common equity. If we click on FINANCIALS, we can see immediately from the balance sheet the amount of MMM's long-term debt and common equity (as of mid-2004, MMM had no preferred stock). Alternatively, you can click on FUNDAMENTAL RATIOS in the next row of tabs below and then select WORLDSCOPE'S BALANCE SHEET RATIOS. Here, you will also find a recent measure of long-term debt as a percentage of total capital.
Recall that the weights used in the WACC are based on the company's target capital structure. If we assume that the company wants to maintain the same mix of capital that it currently has on its balance sheet, what weights should you use to estimate the WACC for MMM? (In the Capital Structure and Leverage chapter, we will see that we might arrive at different estimates for these weights if we instead assume that MMM bases its target capital structure on the market values of debt and equity, rather than the book values.)
2. Once again, we can use the CAPM to estimate MMM's cost of equity. Thomson One provides various estimates of beta-select the measure that you believe is best and combine this with your estimates of the risk-free rate and the market risk premium to obtain an estimate of its cost of equity. (See the Thomson One exercise for Chapter 6 for more details.) What is your estimate for the cost of equity? Why might it not make much sense to use the DCF approach to estimate MMM's cost of equity?
3. Next, we need to calculate MMM's cost of debt. Unfortunately, Thomson One doesn't provide a direct measure of the cost of debt. However, we can use different approaches to estimate it. One approach is to take the company's long-term interest expense and divide it by the amount of long-term debt. This approach only works if the historical cost of debt equals the yield to maturity in today's market (that is, if MMM's outstanding bonds are trading at close to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt.
For example, if a company issues a lot of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in interest expense on the annual income statement because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt.
Another approach is to try to find this number in the notes to the company's annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as www.bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMM's tax rate (which has averaged about 30 percent in recent years). What is your estimate of MMM's after-tax cost of debt?
4. Putting all this information together, what is your estimate of MMM's WACC? How confident are you in this estimate? Explain your answer.