P&g Case Study - Cost of Capital Analysis

Procter & Gamble

Cost of Capital Analysis

FINA0303/2311

Assignment 1

Feb. 9, 2014

Brandon Sun (3035212535)

Jiayi Zhou (2011810474)

Kadura Anton Erik (2011538038)

Nicolas Hartmann (3035212377)

Ye Peng (3035085566)

Table of Contents

Executive Summary        

Issues        

1.        

2.        

3.        

4.        

5.        

6.        

Conclusion        

Appendix        

Appendix A – Clorox WACC Analysis        

Appendix B – Clorox Dividend Growth Model        

Appendix C – Clorox Earnings Capitalization Model        

Appendix D – Industry Comparables        

Bibliography        

To: Ron Emory (President of CORPSTRAT)

From: Mary Shiller

Re: Cost of Capital Analysis

Executive Summary

In identifying the weighted average cost of capital (“WACC”) for a client company of CORPSTRAT, henceforth known as the “client”, who is looking to enter the household-products market, it is necessary to look at comparable companies who are currently in the market. Procter and Gamble (“P&G”), a longtime leader in the household-products segment, was chosen as a suitable benchmark to help determine the client’s WACC.

Having calculated a WACC for P&G of approximately 11%, it was determined that additional research was necessary to help further benchmark and identify an appropriate cost of capital for the firm’s client. Clorox, a firm specialized in detergents and cleaners but with diversified operations in the household-products market, was found to be a suitable comparable for the client and thus its WACC was calculated to be 12.47% using the CAPM method for calculating cost of equity. Additional benchmarking was completed between Clorox and P&G to reduce the bias associated with differing capital structures. With an 11.4% debt to total capital ratio, P&G’s WACC drops down to only 8.56% compared to Clorox’s WACC of 12.47%. Whereas, with a 35.0% debt to total capital ratio, Clorox’s WACC of 11.44% is still notably higher than P&G’s WACC of 10.96%. After stripping and re-leveraging both firm’s capital structures to match one another’s, it’s clear that results were in-line with expectations and add further credence to the idea that both costs of capital for Clorox and P&G would be suitable comparables to find the client’s WACC.

Additional calculations using both the dividend discount and earnings capitalization models also yielded results in-line with expectations. Moreover, the industry average WACC for 1989 was calculated to be 11.43%, only slightly above P&G’s estimated WACC of about 11.00%. The max was also situated comfortably at 14.68% for Avon Products which is only slightly higher than the estimated 12.47% WACC for Clorox. Once a cost of capital can be identified for the client, the next step would be to utilize both NPV and IRR calculations to determine whether it would be worthwhile for the client to enter the household-products market. However, additional information would be required to do so. For now, please see the following for a breakdown of the key analysis of cost of capital for P&G, Clorox, and the client’s other potential benchmarks.

Issues

1. In order to calculate the WACC of Clorox, the cost of debt and the cost of equity need to be determined first.

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As Clorox has no publicly traded bonds, it’s assumed that the cost of debt for Clorox is equal to the cost of debt for P&G. Given the difference in size, this is a strong assumption. Generally speaking, larger companies can access debt cheaper than smaller companies. Thus, this estimate has a positive bias. The number for cost of debt used in this example is 9.18%.

Considering the cost of equity, the CAPM is applied. As Clorox competes in the same industry as P&G, the market risk premium associated with Clorox equals the one of P&G. Furthermore, the risk-free rate is the same. Hence, the only difference is the beta. Clorox’s beta is 0.90 whereas P&G’s beta is 0.95. This leads to lower cost of equity for Clorox.

The last part in order to calculate the WACC is the leverage. Debt encompasses only interest-bearing liabilities. Therefore, Clorox is highly equity financed with a debt to total assets ratio of 11.40% based on 1989 balance sheet figures of 101,289,000 of commercial paper, current maturities of long-term debt, and long-term debt and other obligations as well as 786,176,000 of equity. Consequently, Clorox’s WACC is closer to the cost of equity than the cost of debt and comes down to approximately 12.47% as shown in Appendix A. This figure is greater than P&G’s cost of capital at about 10.96% which makes intuitive sense since Clorox is a comparatively smaller company and less diversified, suggesting higher business risk. In addition, Clorox’s capital structure uses very little interest-bearing debt, especially when compared to P&G, and since the cost of debt is lower than the cost of equity, Clorox would naturally have a lower overall WACC.

However, this also suggests that to compare these two WACCs properly, one must strip out the effects of capital structure to focus solely on the respective firm’s business risks in order to identify which firm truly has a higher cost of capital. Please refer to issue 6 later in the report for an analysis of the company’s WACCs, without the effects of capital structure.

2. Mr. Ron Emory’s method basically relies on using average yield (annual coupon rate divided by average bond price) plus the pricing discount of the bond, which is dependent on whether it is a discount bond or premium bond, to get a “total return” for the bond based on capital return in the form of: 1) coupon payments and 2) appreciation in bond value as discount is reduced overtime due to the bond approaching maturity and thus redemption of its principal.