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102
Cost of Capital

Auto Hut, Inc.

In 1985, while he was taking a course on entrepreneurship at Midwestern University, Jack Cahill wrote a term paper on the management of auto repair shops. Jacks uncle owned a repair shop, and Jack had worked for him when he was in high school and college. Based on his business courses, Jack recognized that most of these shops were inefficient, especially in inventory and receivables management. Thus, most had excessive stocks of some items, shortages of others, frequent stockouts, late payments, bad debt losses, and dissatisfied customers. Still, in spite of their inefficiency, the average repair shop was profitable. Jack concluded that someone could buy several inefficient repair shops, consolidate them into a corporation large enough to use computers to manage inventories and receivables, and thus increase both efficiency and profits. In 1986, John Foss, Jacks uncle, decided to retire. With encouragement from his family and a professor, Jack decided to put his theory to the test, so he bought his uncles shop subject to a purchase money mortgage to be repaid from the business cash flow. Thus Auto Hut, Inc., was born. Jack then borrowed $200,000 from some family friends and arranged a $100,000 bank loan secured by the business assets. With this $300,000, he purchased computers and software, and trained his employees to use the new equipment. Everything went so well that profits rose even more rapidly than Jacks most optimistic forecasts. Within a year, the bugs were out of his computer system, and he began to look for additional acquisitions. He took over two new shops in late 1987, sending employees from the first shop to help run the new ones. Managers compensation, which consisted of a package of cash and stock, was linked to performance. The acquired shops were as successful as the first one, so Jack bought three additional shops in 1988. Acquisitions continued at an increasing pace thereafter, and by 2002 Auto Hut owned a total of 243 shops located throughout the Midwest. Jack used retained earnings plus common stock, preferred stock, and first mortgage bonds to finance acquisitions and to open de novo shops. In addition, he used trade credit plus bank loans to help meet working capital needs. He also considered convertible securities, but to date no convertibles have been issued. Currently, Auto Hut has 12,452,200 common shares outstanding, of which Jack owns 17 percent. The stocks last trade was at $30.50 per share. Since the companys inception, Jack has been personally involved in all facets of the business. He is satisfied with the service his shops provide, with the companys inventory and receivables management, and with the marketing program. However, he has become increasingly uneasy about the company's financial management, an area in which he has no special expertise. The recently retired controller had been responsible for most financial matters, but with the rapid growth in the
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Cost of Capital

scope and size of the business, financial decisions had been getting increasingly complex. Further, competition from large corporations such as Sears, Wal-Mart, and auto dealerships has been increasing. So, in late 2001, Jack concluded that to ensure continued success, he must establish a finance group with as much competence and sophistication as those of his competitors. Therefore, he hired Mike Walinski, a senior financial executive with a major retail chain, as vice president and CFO. Walinski began by reviewing financial statements and ratios shown in Tables 1, 2, and 3, after which he turned to Auto Huts procedures for evaluating capital expenditure decisions. After going over the procedures manuals and the supporting analyses for recent capital investment decisions, he concluded that the company's approach was for the most part appropriate. The firm relied on discounted cash flow (DCF) analysis to arrive at accept/reject decisions for projects; it estimated future cash flows on an incremental basis; and it discounted cash flows at a weighted average cost of capital (WACC). However, the estimate of the cost of capital itself was questionable. In the most recent capital budgeting session, at year-end 2001, the since-retired controller used a before-tax debt cost of 10 percent, which was equal to the coupon rate on Auto Huts last (1999) longterm first mortgage bond issue. These bonds are rated BBB, will mature in 17 years, and can be called in 3 years. For the cost of equity, the controller used the year-end earnings yield (EPS/Price) of 7.5 percent, based on an earnings per share of $2.30 and a share price of $30.50. His justification for using the EPS/Price yield was that since investors were getting $2.29 of earnings for a $30.50 investment, they were willing to accept a 7.5 percent rate of return on their money. Also, the controller noted that if the company could sell stock for $30.50 per share and invest the proceeds at a 7.5 percent rate of return, earnings per share would remain constant at $2.29. In addition, he noted that this 7.5 percent is below the interest rate on debt, and that since the company would sell stock only to finance projects that would earn more than the 7.5 percent cost of equity, capital budgeting would lead to higher earnings per share. Auto Hut also has outstanding some 7 percent, annual payment, $100 par value, perpetual preferred stock. The preferred recently closed at a price of $105 per share. However, the firms investment bankers informed Walinski that any new preferred stock will have to carry a $6.67 annual coupon, while 10 percent of the original amount issued must be called (at the $100 par value) and retired each year. Flotation costs for new preferred would be $2.50 per share. Walinski then hired your consulting firm to analyze Auto Huts situation and to make a recommendation as to how the cost of capital should be calculated. He provided the information given in Tables 1 through 4. Walinski is interested in both the costs of the different capital components and also the weights used to calculate the WACC. The retired controller used book weights based on the actual capital structure, and he considered only long-term capital. His reasoning was that this is the way the capital used to finance capital budgeting projects was actually raised, and also that Moodys, S&P, and most security analysts focus on accounting data. He also noted that market value weights would vary with stock prices, hence would be unstable and would result in a fluctuating WACC, which would destabilize the capital budgeting process. The controller also toyed with the idea of using target capital structure weights, but he decided not to. Earnings and dividends per share over the last 5 years are shown in Table 3. Some analysts expect the same growth rate in the future as in the past, while others expect growth to decline as the
57 - 2 Copyright 2000 by The Dryden Press. All rights reserved.

company saturates its market. A survey showed that the average of all analysts 5-year growth rate forecasts is about 16 percent, but the survey provided no information on what growth rate the analysts expected beyond the fifth year. However, one highly-regarded analyst recently published a report in which he stated that he expects the growth rate to average 20 percent over the next 3 years, 15 percent over the following 3 years, and then 11 percent thereafter, in the long-run. Another widely followed analyst stated that she expects the dividend growth rate for 2002 to be 20 percent, after which the rate would decline each year for 15 years, and then stabilize at a constant long-run rate of 10 percent. Walinski himself has an idea about what the dividend growth rate will be, but he knows that the cost of capital is based on investors analysts forecasts, not on his views, even though he may know more than the investing public. Your consulting firms analysts have been using a 5 percentage point market risk premium for stocks over 10-year Treasury bonds. Also, your firms analysts have been citing a report by a leading security analyst who asked portfolio managers what risk premium they require on a given companys stock over its bonds. The analyst then compiled the results and concluded that unless portfolio managers think they can earn about 5 percentage points more on a given companys stock than on its bonds, then they will not invest in the stock. The analyst also performed a study similar to the one shown in the tab labeled RP Study in the case model, 102modl. That study suggests a risk premium over a companys own debt in the 3 to 5 percent range. Finally, based on historical data, Ibbotson Associates, in their most recent Yearbook, concluded that the risk premium for stocks over T-bonds is about 8 percent, while the premium of stocks over corporate bonds is about 7 percent. Ibbotsons conclusions are based on data that give equal weight to each year from 1926 to 2001, and their procedure assumes that investors expect future returns to resemble past returns, so their conclusions may not be indicative of investors actual forward-looking risk premiums. Several years ago, at the time of Auto Huts IPO, the investment bankers suggested that the companys capital structure should consist of 30 percent long-term debt, 5 percent preferred stock, and 65 percent common equity. Those numbers had then been included in the companys strategic business plan. However, no mention was made of whether the target should reflect book or market values, nor was it clear if the capital structure should be based on all debt or only long-term debt. A professor in an executive program that Walinski had attended stated that the focus should be on long-term securities market values, but the professor also noted that bond rating agencies as well as many bankers, security analysts, and corporate executives focus on book values. Auto Huts target has never been achieved, but Jack Cahill nevertheless regards it as a reasonable target that the company should try to achieve at some time in the future. Here is some additional information that Walinski wants you to incorporate into your report. (1) Auto Huts historical beta as measured by several analysts is 1.3. (2) The going interest rate on BBB-rated long-term corporate bonds with maturities in the range of 15 to 20 years is about 8 percent. (3) Auto Hut is forecasting 2002 earnings after preferred dividends of $34,254,000 and depreciation of $9,000,000. (4) Management expects to pay out about 20 percent of earnings as dividends. (5) Auto Huts investment bankers believe that a new issue of common stock would require flotation costs (including underwriting costs, market pressure from increased supply, and

Copyright 2000 by The Dryden Press. All rights reserved.

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market pressure from negative signaling effects) of as much as 30 percent. Auto Huts federal plus state tax rate is 40 percent. To help sharpen your focus, Walinski and your boss met and developed the following set of questions, which you are to be prepared to answer in your presentation and report. Questions About the Case 1. Is Jack Cahill concerned about losing control of the company, and does that make him reluctant to finance with new common stock? Is Mike Walinski completely satisfied with all aspects of Auto Huts capital budgeting procedures? How did the former controller estimate the cost of debt for use in the WACC calculation? Do you agree with his procedure? How did the former controller estimate the companys cost of common equity for the WACC calculation? Do you agree with his procedure? What weights did the controller use to calculate the WACC? How did he justify his choice for these weights? Do you agree with his choice?

2.

3.

4.

5.

6. Based on the information given in the case, should we find Auto Huts DCF cost of equity by use of the constant growth formula or by some sort of non-constant growth formula? 7. What information provided in the case can be used to find Auto Huts CAPM cost of equity? 8. What information provided in the case can be used to find Auto Huts cost of equity as measured by the risk-premium-over-own-debt method? 9. If Auto issues new preferred stock, will it be perpetual or will it have a finite life? Questions That Require Calculations 10. What is Auto Huts component cost of debt for purposes of calculating the WACC? When answering this question, be sure to consider the different types of debt used, flotation costs (which you may or may not want to include in the calculation), and taxes. Also, consider the YTC versus the YTM as an estimate of the cost of debt, and discuss alternative ways of obtaining the rate of return investors require on Auto Huts 20-year debt. Assume the bonds have a whole number of years to call or maturity, but be prepared to explain how yields could be estimated if we were between interest payment dates.
57 - 4 Copyright 2000 by The Dryden Press. All rights reserved.

11. Now consider Auto Huts 7%, annual payment, $100 par value, perpetual preferred stock that currently sells for $105 per share. a. What pre-tax return do investors expect on the preferred stock? Is the relationship between this return and that on the companys bonds reasonable? b. Auto Huts outstanding preferred stock is perpetual, but most new issues of preferred have sinking funds that limit their lives. Auto Hut will be required to include a sinking fund that calls for retiring 10% of the original issue each year. The new preferred would have a $6.67 annual dividend, a $100 par value, a $2.50 per share flotation cost, and a sinking fund call price of $100. What pre-tax yield do investors expect to earn? c. What is Auto Huts component cost of preferred stock for use in the WACC calculation? 12. Why is there a cost associated with retained earnings? 13. Now consider the CAPM approach to the cost of common equity. a. Why might one argue that the T-bond rate is a better estimate of the risk-free rate than the T-bill rate? What arguments could be given for using the T-bill rate? Would the choice affect how the market risk premium is estimated? How would the slope of the yield curve enter into the choice of the bond versus the bill rate, and the effect of that choice? b. How do historical betas, adjusted historical betas, and fundamental betas differ? As an estimate of future risk, would Auto Huts historical beta be more or less accurate than the historical beta for a portfolio as a measure of the portfolios risk? In other words, are historical betas better predictors of risk for individual stocks or for portfolios of stocks? Does this affect the cost of capital estimation process? c. Describe several ways to obtain a market risk premium for use in a CAPM cost-of-equity calculation. d. What is Auto Huts cost of retained earnings as estimated by the CAPM method? 14. Use the own-bond-yield-plus-risk-premium method to estimate Auto Huts cost of retained earnings. What are the major pros and cons of this method? 15. Now consider the DCF approach to the cost of common equity. a. Auto Hut, over the last few years, has on average earned 20 percent on its common equity, and it has paid out about 20 percent of its net income as dividends. Management has a target of 20% for ROE in the future. How might this information be used to help estimate the firms expected DCF growth rate, g? What conditions are necessary for this to be a valid procedure? Do those conditions exist for Auto Hut? b. Based on the data given in the case, what are the firms historical dividend and earnings growth rates using (1) the point-to-point calculation method and (2) a regression procedure? Which method is better? c. Many security analysts are forecasting a 16 percent growth rate for Auto Hut over the next 5 years, but these analysts give no information for growth beyond Year 5. However, one analyst is forecasting 20 percent for the next 3 years, 15 percent for the following 3 years,
Copyright 2000 by The Dryden Press. All rights reserved. 102 - 5

Cost of Capital

and 11 percent thereafter, and another forecasts a constantly declining growth rate for the next 15 years. How can this information be used to make a DCF estimate of the cost equity? d. What do you regard as a reasonable range for Auto Huts DCF cost of retained earnings? What is the single best DCF estimate? 16. Based on all the information availableCAPM, DCF, and over-own-bond-cost--what is a reasonable range for Auto Huts ks, and the single best point estimate? Justify your answers. 17. If Auto Hut expands so rapidly that it must issue new common stock, what is your estimate of the cost of capital from new stock, ke? 18. Now consider the weighted average cost of capital, WACC. a. What is Auto Huts WACC if all of its equity comes from retained earnings, and what is its WACC if it must issue new common stock? b. Assuming the company uses its target capital structure to raise capital, how large could the capital budget be before new common stock must be sold? c. Would the MCC schedule remain constant beyond the retained earnings break point no matter how much new capital the firm raises? d. How does depreciation affect the MCC schedule? If depreciation were simply ignored, would this affect the acceptability of proposed capital projects? e. Should the company attempt to adhere rigidly to its target capital structure? If not, how would this affect the calculated cost of capital? 19. Currently, the company uses the corporate cost of capital as developed above to evaluate all projects, regardless of their individual characteristics. What does this procedure assume about projects risks? Should this procedure be changed? 20. Now suppose Auto Hut is offered a chance to acquire a chain of 10 repair shops for a total cost of $10 million. Its regular capital expenditures are expected to be somewhere in the range of $20 to $70 million, with the exact amount to be decided later, when more information is available. If the acquisition is completed, the new shops are expected to provide Auto Hut with a total incremental after-tax net cash flow of $1.16 million per year for 20 years, at which time they will be have a value of about $5 million. The risk of the new chain is about the same as that of Auto Huts existing assets. a. Based strictly on a discounted cash flow analysis, should Auto Hut make the acquisition?

b. If your estimated cost of capital were 2 percentage points too high or too low, how would that affect the estimated value of the acquisition? Is it likely that
57 - 6 Copyright 2000 by The Dryden Press. All rights reserved.

your estimate of WACC could be off by as much as 2 full percentage points? (Note: Goldman Sachs, a top investment banking firm, recently estimated Rubbermaids cost of capital to be in the range of 9 to 13 percent. Goldmans analysis was conducted as part of an evaluation of a due diligence study to see if the price Newell Corporation was offering for Rubbermaid was fair and reasonable.)

Table 1. Auto Hut Income Statement, 2001

(Millions) Net sales Cost of goods sold Gross profit Admin and selling exp Depreciation and amortization Miscellaneous expenses Total operating exp EBIT Interest on ST loans Interest on LT debt Total interest Before-tax earnings Taxes (40%) Net income Preferred dividends Net income applicable to common Dividends on common stock Additions to retained earnings EPS DPS $800,934 640,954 $159,980 $68,080 8,160 20,264 $96,504 $63,476 $6,032 7,200 $13,232 $50,244 20,098 $30,146 1,600 $28,546 $5,710 $22,836 $2.29 $0.46

Copyright 2000 by The Dryden Press. All rights reserved.

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Cost of Capital

Table 2. Auto Hut Balance Sheet, 2001 (Millions)

Cash and securities Accounts receivable Inventory Current assets Land, buildings, plant, And equipment Accumulated depreciation Net fixed assets $10,000 92,572 148,130 $250,702 Accounts payable S-T bank loans Accruals Current liabilities Long-term bonds Total liabilities Stockholders equity: Preferred stock Common stock Retained earnings Total stockholders' equity Total liab. and equity Book value/share $77,974 70,960 29,324 $178,258 80,000 $258,258 $20,000 40,000 118,594 $178,594 $436,852 $12.74

$212,926 -26,776 $186,150

Total assets

$436,852

Table 3. Earnings and Dividends per Share, 1997-2001

Year 1997 1998 1999 2000 2001

DPS $0.12 0.30 0.30 0.33 0.46

EPS $0.60 1.26 0.52 1.90 2.29

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Copyright 2000 by The Dryden Press. All rights reserved.

Table 4. Auto Hut's Ratios, 2001 Part I. Traditional Ratios Current ratio Quick ratio Total debt/Total assets Long Term debt/Long-term capital Preferred stock/Long-term capital Times interest earned (TIE) Inventory turnover Days sales outstanding Total assets turnover Profit margin Return on Equity (ROE) P/E ratio Market/Book ratio Payout ratio Part II. S&P's Key Ratios1 EBIT interest coverage (same as TIE) EBITDA interest coverage Funds from operations/Total debt Free operating cash flow/Total debt Return on Capital Operating income/Sales Long-term debt/Capital Total debt/Capital Auto Hut 1.41 times 0.58 times 59% 31% 8% 4.80 times 5.41 times 41.61 days 1.83 times 3.56% 15.98% 13.30 times 2.39 times 20% Reference2 BBB+ BBBNA3 BBB+ A CCCA BBBNet for common plus deprn/Total debt Assume deprn = cap exp, NWC = 0, so FCF = NI EBIT/Avg cap, incl short-term bank debt (EBIT + Deprn)/Sales Long-term debt, preferred, and common equity. Excludes S-T debt other than bank debt.

Industry Average 1.6 0.62 56% 43% 4.40 5.20 39.10 1.71 3.41% 14.22% 11.60 2.00 23%

4.80 5.41 14.21% 11.67% 18.16% 8.94% 28.72% 54.19%

S&P's definitions are a bit more complicated than we show here, as they make additional accounting adjustments. The S&P information is available from various sources. We got the following data from www.standardandpoors.com, and then Resource Center > Ratings Criteria > Corporate Finance > Ratings and Ratios. You may have to hunt around the S&P site, as things change. 2 S&P provides median ratios for companies with different ratings. We show the ratings that are consistent with Auto Hut's ratios.
3

NA = Not Available. S&P did not provide a reference for this ratio.

Copyright 2000 by The Dryden Press. All rights reserved.

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Table 5. Information Related to Auto Hut, Inc. as of 12/31/01

1.

The end-of-year bond quote on Auto Huts 10% coupon, 20-year, semiannual payment bond indicated that it sold at a price of 120.9. These bonds are callable in 3 years at $1,100, and they are rated BBB. 20-year BBB-rated bonds are currently yielding about 8 percent End-of-year quotes on Auto Huts common and perpetual preferred stock were as follows: 52 Weeks Hi Lo 31.5 26.5 110 98 Stock Auto Hut Auto Hutpf Sym Div Yld % PE Vol 100s 356 67 Hi 31 105 Lo Net Close Chg

2.

HUT 0.46 HUTP 7.00

1.5 13.3 6.7

30 30 +1/2 102 105 +3/4

3.

End-of-year quotes on long-term treasury bonds: Coupon Rate 10 3/8 10 5/8 7 5/8 Maturity Mo./Yr. Dec. 09 Dec. 19 Dec. 29 Bid 133:06 144:08 113:22 Asked 133:10 144:10 113:24 Chg 3 6 6 Ask Yld. 6.27 6.61 6.57

4.

End-of-year quotes on treasury bills: Days Maturity to Mat. July 30 90 Bid 5.44 Asked 5.42 Chg. 0 Ask Yld. 5.57

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Copyright 2000 by The Dryden Press. All rights reserved.