Hienz - WACC Analysis


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Analysis using WACC

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Hienz - WACC Analysis

  1. 1. Analysis & Proposal – Weighted Average Cost of Capital1 SummaryWeighted Average cost of capital (WACC) for Heinz had been a subject of controversy due to three mainreasons – Share price of Heinz for last three years, low interest rates in market and current financial melt-down.The following report analyses these conditions and determines a WACC given the set of conditions provided.2 Factors Effecting WACCVarious factors that affect the Weighted Average cost of capital (WACC) computation for Heinz are - MarketRisk Premium, Cost of Debt, Cost of Equity, and Heinz Risk relative to Market. In order to precisely estimate thecost of capital we will present our thought process in computation of various factors.2.1 Market Risk Premium AssumptionOur analysis took a long term approach and measured the averagemarket risk premium to be around 7.5%. However, whenmeasured over shorter time periods, this premium varied greatlyfrom 5% to 9%.Market RiskPremium7.5%2.2 Analysis of Cost of EquityFor determination of Beta (β) we used historical values from Jan2001 till April 2010 of Heinz and Market, and found out the co-relation between them using regression. We also analyzed thecompany’s Beta using market data, where sources used onlyprevious five years as a comparison strategy.Further, we used 10-year US government bonds as the risk-freerate.Using the above information we compute the Cost of Equity usingthe following equation, Where R(e) is Cost of Equity, R(f) is riskfree rate and (E(Rm) –R(f)) is the value of market risk premium.Further, we found that the cost of a share was $46.87. Thus, using this information and the number ofshares outstanding we have: Market Value of Common Equity = Price of one share x Number of sharesoutstanding.Market Value of Common Equity 46.87 X 317690000=14890130300Beta ( 10 years of data) 0.441Beta (Market Sources) 0.62R (f) 0.369Cost of Equity (using computed Beta) Cost of Equity (Market value of Beta)0.0834 0.069975
  2. 2. 2.3 Analysis of Cost of DebtOur analysis assumed that the book value (from 10K) of short-term debt is equal to the market value of short-term debt and thebook value (from 10K) of long-term debt is equal to the marketvalue of long-term debt.During our analysis, welooked into the marketdata sources todetermine the yield andcoupon rates of our debtfor the year 2010.We considered thecurrent portion of longterm debt, short termdebt and long term debtto get the total debt.3 Computation of WACCIn order to compute the WACC we used the marginal tax rate to 35% and Market Risk Premium as 7.5%.Further WACC is the sum of cost of debt and cost of equity. The formula that we use for computing WACC isWACC = R(d) (1- Tc )*( D / V )+ R(e) *( E / V )Cost of Debt Cost of Equity WACCWACC (beta 0.441) 0.006902331 0.063849672 0.060474WACC (beta 0.62) 0.006902331 0.063849672 0.0707524 Assumptions & Estimations4.1 Standard Errors in EstimationThe estimation of the WACC is based on several key assumptions:o It is market driven. It is the expected rate of return that the market requires to commit capital to aninvestment.o It is a function of the investment, not the investor.o It is forward looking, based on expected returns.o The base against which the WACC is measured is market value, not book value.o It is usually measured in nominal terms, which includes expected inflation.Long Term Debt 4559152Short Term Debt 43853Year Coupon Maturity Price Yield Book Valueof DebtBook value ofWeighted Debt2010 0.0675 3/15/2032 116.9 0.0453 4559152000 206529585.62010 6.625 10/15/2011 107.5 0.0041 43853 179.7973Long term Debt 4559195853 0.045299604Long term Debt 4559195853Current portion of long term debt 15167Short term Debt 43853Total Debt 4559254873Market ValueCost of Debt R(d) 4559254873Cost of Equity R(e) 14890130300Total of Cost of Debt & Cost of Equity V 19449385173
  3. 3. o It is the link, called a discount rate, which equates expected future returns for the life of theinvestment with the present value of the investment at a given date.Precision on our estimation is based on the following assumptions made during – Calculation of Market RiskPremium, Calculation of Beta and Calculation of risk free rate. We assumed a long term approach for theMarket risk premium and assumed the value to be 7.5%. We ran a regression on the data we had for thereturns of Heinz and the market from January 2001 to April 2010 to compute the Beta. The standard errorof the regression is 0.043, so we feel very confident given the data that our calculation of Beta representsthe long term relationship between the market return and the returns for Heinz.We also calculated the WACC using market risk premiums ranging from 5% to 9% and using both thecomputed beta and the beta from the market sources. We see the following results:As we can see, by varying the risk premium and the beta, the WACC ranges from 5.2% to 7.78%. This is notfar from the calculation we have in 3 above.4.2 Market Risk Premium EstimationsMarket risk premium used by the analysis was based of a long term approach. While developing a plan forlong term, we used 7.5% as market risk premium, but we also analyzed how for a particular Beta, the WACCchanged with market risk premium. The WACC ranges between 6.55% and 5.2% by using different marketrisk premiums. The value 7.5% is a good estimate because it lies in the middle of the spectrum. So, we cansay that we are neither being too aggressive, nor too conservative with that value. Our recommendation isto use 7.5%Beta =0.041 Beta = 0.62Market riskPremiumWACC Market riskPremiumWACC9% 6.554% 9% 7.787%8% 6.216% 8% 7.313%7.50% 6.047% 7.50% 7.075%6% 5.541% 6% 6.363%5% 5.203% 5% 5.889%4.3 Government Bond Rates and risk free rateThe financial crisis and aggressive federal government actions have caused the Government bond rates tobe unusually low. However, they have also caused the inflation rate to be low. When thinking about thebond rates, it’s important to look at the real rates, not the nominal rates. Therefore, we feel that there is noneed to adjust the risk free rate to reflect these conditions.Market risk Premium Beta Cost of Debt Cost of Equity WACC9% 0.441 0.0069 0.0586 6.554%9% 0.62 0.0069 0.0710 7.787%8% 0.441 0.0069 0.0553 6.216%8% 0.62 0.0069 0.0662 7.313%7.50% 0.441 0.0069 0.0536 6.047%7.50% 0.62 0.0069 0.0638 7.075%6% 0.441 0.0069 0.0485 5.541%6% 0.62 0.0069 0.0567 6.363%5% 0.441 0.0069 0.0451 5.203%5% 0.62 0.0069 0.0520 5.889%