Procter ; Gamble: Cost of Capital
Determine the cost of capital for CORPSTRAT’s client to enter the household products market to decide if entry would be worthwhile.
Cost of Capital for Clorox
First, we make an assumption that Clorox’s cost of debt is equal to Procter and Gamble’s cost of debt which is equal to 9.19%. The cost of equity for Clorox calculated using CAPM is found to be approximately 13.33%. Clorox cost of equity can also be calculated using the dividend growth model using the following data from the financial statements:
Dividend = $1.09 per share
Dividend Growth = 13.5%
Stock Price (Current) = $38.25
Cost of Equity (K) = (Div/P) + Div Growth
K = (1.09/38.25) + 0.135 = 0.163 or 16.3%
Average cost of equity for Clorox = (16.3 + 13.33)/2 = 14.82%
To get the cost of capital WACC, the cost of each capital source (equity and debt) is multiplied by the relevant weight respectively and the products are added. Using 1989 balance sheet data, we let the debt = 101, 289, 000 for all debt obligations. The total equity is calculated by multiplying the stock price with the market value of its shares that are outstanding (17, 000, 000 * $40 per stock = 680, 000, 000). The total enterprise value is 781, 289, 000 and the Tax rate is 34%.
Using this data, WACC = E/V * Re + D/V * Rd* (1-Tc)
WACC = (680000000/781289000)*(0.1482)+(101289000/781289000)*(0.0919)*(1-0.34)
WACC = 0.136 or 13.6%
Previous analysis of Procter and Gamble was not an accurate representation of a new entry due to its market share in the industry as well as the financing strategy. Clorox was used as a proxy, reflecting a company with smaller market capitalization.
Initially, it was perceived that since Procter and Gamble Company was dominant in the market and because of this, it did not offer a good basis for benchmark in the market. When benchmarking for purposes of establishing a new company that deals in the same product line as an existing company, it is more critical to bench mark companies that are at the entrant level like the Clorox in order to get a more realistic picture of the market. For instant, Procter and Gamble had a large market capitalization of $ 21.4 billion while Clorox had a small market capitalization of only $ 2.2 billion. This made Clorox more suitable for comparison with other new entrants into the market that Procter and Gamble.
The Capital Asset Pricing Model (CAPM) is used to indicate the relationship that exists between the expected return and the risks that are involved in an investment. This implies that the CAPM is used for showing the amount of benefits that the investors will demand or receive for any additional risk that they make in riskier investments. As a result of this, the security risk premiums are usually proportional to stock beta. In this case, derived return on equity was 13.87% and the calculations used involved a risk free rate of 8.47% on a return of 10 year bond because the project was long term, beta equity of 0.9998, risk free premium of 5.4% and common stocks on bonds between 1926 and 1988. This method is commonly used to value new or small businesses like the client used in this case, and not companies like Procter and Gamble which had a large market valuation.
For a company to accurately calculate its cost of capital, it should ensure that it calculates the cost of retained earnings as a constituent of its cost of capital. The cost of retained earnings is the return that the shareholders for a company require on its common stock. As a result, it is included in the calculation of the WACC of a company. CORPSTRAT chose to use the data on cost of debt of 8.22%, leverage ratio of 0.114 and corporate tax rate of 34% to calculate the WACC. WACC can be calculated in different ways and as an analysis organization; it is the role of CORPSTRAT to use the most cost effective method. From the results, the adjusted WACC was found to be 12.91% while a return on the equity using the accounting method, of the net shareholder’s equity/income yielded 15.79%.
While making a decision for the client, CORPSTRAT should make the consideration that since it is a fact that Procter and Gambler’s debt cost of 9.19% would act as a proxy for Clorox’s lack of publicly traded bonds, the cost of equity will play a vital role in decision making. The two companies have similar risk free rate because they operate in the same line of business. Clorox has a smaller cost of equity of 13.33% as compared to Procter and Gamble’s 13.6%. Therefore, Clorox can be said to have larger WACC than P&G because of P&G’s larger debt. Mr. Emory’s suggested not to use the dividend growth model because of the Clorox’s small market capitalization. Small market capitalization is inconsistent and would not be sustainable and instead, the clients should consider P;G with WACC of 12.6% as the most appropriate benchmark for them to enter into the market.