Western is a holding company which owns two regulated utilities plus a third subsidiary which

invests in unregulated energy projects. Westerns only function is to provide capital and staff sup-
port to the subsidiariesit is strictly a holding company. All cash ows generated by the subsidiaries
are controlled by Western, which uses funds to support its staff, to pay dividends, and to reinvest in
its subsidiaries. Funds are allocated back to the subsidiaries depending on their investment oppor-
tunities, not in proportion to the amount of funds sent up to the parent company. The subsidiaries
raise debt and preferred stock by issuing their own securities, but they need common equity over and
above the amount of funds sent back by the parent company (retained earnings). Western issues
bonds, preferred stock, and/or common stock and then uses the proceeds to buy common stock in the
subsidiary. Both the subsidiaries and Westerns bonds and preferred stocks are traded in the pub-
lic market, but the subsidiaries securities are not actively traded so valid quotations are available
only for Westerns debt and preferred stock. Also, Westerns common stock is publicly traded.
Western is contemplating not using preferred stock in the future, but a nal decision has not
been reached. The company goes through its budget process in the fall. At that time, capital expen-
ditures for the coming year are authorized, and plans are made to raise any required external capi-
tal. Also, the Board makes a tentative determination of executive bonuses for the year, and it
approves the operating targets upon which the following years compensation will be based. West-
erns nancial staff also compares the utility subsidiaries earned rates of return to their authorized
rates of return, and their authorized returns to estimates of their costs of capital. If the utilities are
projected to earn a lower rate of return on equity than their regulatory commissions have autho-
rized, or if the authorized return is less than the cost of equity as estimated by management, then
the subsidiaries will seek rate increases.
Western has been relying on the consulting division of its accounting rm to develop estimates
of the cost of capital. When Tina Clark, Westerns recently hired CFO, received the accountants
cost of capital estimates, she was struck by signicant differences between the accountants calcu-
lations and the procedures she was used to seeing. She then asked your consulting rm to do an inde-
pendent cost of capital study, and you were assigned that task.
Tina explained that she needs the cost of capital for regulatory purposes, for evaluating pro-
posed capital expenditures, and for calculating Economic Value Added (EVA). She provided the
nancial statements and miscellaneous information contained in Tables 1 through 4.
Copyright 1994. The Dryden Press. All rights reserved.
Case 75
Capital Budgeting
The Western Company
Directed
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Tina knows that the cost of capital will be controversial, so she wants you to justify your cal-
culations. Where reasonable people could reach different conclusions, you should present both sides
of the argument, and perhaps express your answers in terms of a range rather than a single number.
Also, you should indicate what effects different cost of capital estimates might have on operations.
Since Tina wants a structured explanation of your ndings, she suggested the following plan
of attack:
1. Some Over-Riding Conceptual Issues
a. In what ways would Western use your cost of capital estimate or estimates?
b. Should book weights or market weights be used to calculate WACC?
c. Should current (marginal) cost rates be used for the capital components, or should histori-
cal (embedded) rates be used?
d. Should one cost of capital be determined and then used for all purposes, or should you
develop a series of different WACCs? If you conclude that the company should use dif-
ferent WACCs for different purposes, how would you suggest that these different
WACCs be determined? Would you use the same or different component costs, the same
or different weights?
2. Component Cost of Preferred stock
a. How would you account for the fact that Western can deduct interest on its debt, whereas
there are no similar deductions for dividends on common or preferred stocks?
b. Given the differences in bond ratings between the utility subsidiaries and the unregulated
subsidiary, would you assume that the various units have the same or different costs of
preferred stock?
c. What number or numbers should you use for the cost of preferred stock in your WACC
estimate? Use the data given in Table 4 to make your estimate(s).
3. Component Cost of Common Equity
a. What method or methods might one use to estimate Westerns cost of common equity?
Discuss (1) the use of T-bills versus T-bonds as the risk-free rate, (2) alternative ways of
estimating the market risk premium, (3) what betas are and how they affect cost of equity
estimates, (4) how growth rates for use in DCF cost of equity studies are estimated, and
(5) how one might estimate the risk premium over Westerns own bond rate to arrive at a
cost estimate for its common stock.
b. Suppose Western, over the last few years, had earned a 14 percent average return on
equity (ROE) and paid out 75 percent of its net income as dividends. Under what condi-
tions could this information be used to estimate the rms expected future growth rate, g?
Estimate ks using this procedure for determining g.
c. Is the cost of equity to the company identical to (1) the required rate of return and/or (2)
the expected rate of return to the marginal investor? Does it matter if the equity whose
cost is being estimated comes from retaining earnings or from issuing new common
stock?
d. What is your estimate of Westerns cost of equity as determined by each of the methods
discussed above, for both retained earnings and new equity raised by issuing stock?
4. Weights for the WACC Calculation
On the basis of information given in the case and in Table 4, what weights should be used to
calculate Westerns WACC? Should the same weights be used for all the subsidiaries? For
all projects within each subsidiary?
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Note that Westerns accounting rm calculated the WACC using book weights based on
the companys actual long-term capital structure. They gave these reasons for their use of
book weights: (1) This is how the capital now employed was actually raised. (2)
Moodys, S&P, and most security analysts focus on capital structures based on book val-
ues. (3) Stock and bond prices uctuate, hence market value weights are unstable, which
would result in a uctuating WACC, which, in turn, would destabilize the capital expen-
diture planning process. For these three reasons, the accountants concluded that the best
choice for weights is the actual book value capital structure. Clark wants your opinion on
what weights should be used, and how much difference the choice of weights would have
on the calculated WACC.
5. Internal versus External Capital
a. Depreciation is one of the largest sources of funds reported on Westerns Statement of
Cash Flows (which is not provided), and it is very large on the income statement and bal-
ance sheet. What is the cost of the funds provided by depreciation? Explain.
b. Beyond what amount of total capital (debt, preferred stock, and common equity) would
Western be required to issue new common stock, assuming the level of retained earnings,
the depreciation expense, the dividend payout ratio, and the capital structure indicated in
Table 4?
c. If depreciation were simply ignored, could this affect capital expenditure decisions?
6. Marginal Cost of Capital (MCC)
a. Construct Westerns MCC schedule from the information you have developed thus far. If
there is any uncertainty inherent in the information you have developed, you could show
the MCC schedule as a band, i.e., an upper MCC, a lower MCC, and a midpoint MCC.
b. Would the MCC schedule remain constant beyond the retained earnings break point (i.e.,
the point where retained earnings are used up and new equity must be issued)? Explain.
c. Would a change in either the capital structure or the dividend payout affect the MCC
schedule you constructed? Could such adjustments cause the MCC curve to be a smooth
curve rather than a step function?
7. Costs of Capital for Different Purposes
a. Should the same WACC be used for regulatory purposes, for internal decisions such as
capital expenditures, and for EVA? Should the three subsidiaries use the same WACC or
different WACCs?
b. Should Westerns corporate WACC, the subsidiaries WACCs, or project-specic
WACCs be used for capital budgeting purposes? Would it matter if the decision pertained
to a capital expenditure related to a generating plant versus the distribution system? To a
utility or to the unregulated subsidiary? In general, investments in distribution facilities
constitute the least risky investment for utilities because competition is least likely to
develop there. Transmission investments are next in risk, and generating plant invest-
ments are the most risky.
c. If a rate case were being heard at a time when the yield curve was upward sloping, would
a consumer witness (who would want to report a low cost of capital so as to reduce the
required level of prots, hence customers bills) who used the CAPM to estimate the cost
of common equity be more likely to use T-bills or T-bonds as the risk-free rate?
8. Using the Cost of Capital in Capital Budgeting
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Tina Clark also wants you to consider how the WACC might affect decisions related to four
major unregulated investment projects. Two of the projects involve the purchase of smaller
utility companies, and the other two are new generating plants. Clark asked you to use the
following information (dollars in millions) for illustrative purposes:
Cash Rate of
Project Cost Life Flow Return
1 $1,000 5 $275 11.65%
2 750 7 157
3 1,000 5 263 9.88
4 500 6 110 8.56
Assume initially that these projects are all equally risky, and also that they are about as risky
as Westerns existing assets. The rate of return for Project 2 is missing, so you must calcu-
late it.
9. Large Merger
Western has also been thinking about merging with another utility, one that is almost as
large as Western. This second company is comparable to Western in many respects, but it
has had nancial difculties. Its bonds are rated BB, and its beta coefcient is 1.1 versus
Westerns beta of 0.65. Would this acquisition affect the consolidated companys cost of
capital, and the costs of capital for Westerns current three subsidiaries? If so, how should
this be handled?
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TABLE 1
The Western Company: Income Statement
for the Year Ended December 31, 1996
(Millions of dollars)
Income Statement Common
Actual Size
Sales revenues $5,144.1 100.00%
Fixed operating costs
(excluding depreciation) 950.0 18.47
Depreciation 509.1 9.90
Variable operating costs 2,181.0 42.40
Total operating costs $3,640.1 70.76%
Net operating income (EBIT) $1,504.0 29.24
Less: Interest 388.6 7.55
Earnings before taxes (EBT) $1,115.4 21.68
Taxes 446.2 8.67
Net income before preferred dividends $ 669.2 13.01
Preferred dividends 61.4 1.19
Net income available to common stockholders $ 607.8 11.82
Common dividends $ 471.8 9.17
Addition to retained earnings $ 136.0 2.64
Common shares outstanding (millions): 399.87
EPS $ 1.52
DPS $ 1.18
Stock price (12/31/96) $ 20.00
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TABLE 2
The Western Company: Balance Sheet
December 31, 1996
(In Millions of Dollars)
Balance Sheet Common
Assets: Actual Size
Cash and securities $ 108.5 0.65%
Accounts receivable 633.6 3.78
Inventory 562.3 3.35
Other current assets 163.8 0.98
Total current assets $ 1,468.2 8.76
Land, Plant, and Equipment $16,184.5 96.53
Accumulated depreciation 3,092.0 18.44
Net xed assets $13,092.5 78.09
Other assets 2,205.3 13.15
Total assets $16,766.0 100.00
Common
Actual Size
Liabilities & Capital:
Accounts payable $ 499.7 2.98%
Accruals 474.4 2.83
Bank loans 748.3 4.46
Total current liabilities $ 1,722.4 10.27
Deferred taxes $ 4,372.8 26.08
Long-term debt 4,707.7 28.08
Preferred stock 887.8 5.30
Common stock $ 3,096.9 18.47
Retained earnings 1,978.4 11.80
Total common equity $ 5,075.3 30.27
Total liabilities and equity $16,766.0 100.00
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TABLE 3
The Western Company, Selected Ratios and Data, 1996
Current ratio 0.85
Quick ratio 0.53
(LT Debt+Pfd)/(Tot LT Cap): at Book 52.44%
LT Debt/Tot LT Cap: at Book 44.12
Times interest earned 3.8
Inventory turnover 9.15
Days sales outstanding 44.34 days
Total assets turnover 0.31
Marginal tax rate 40.00%
Basic earning power 8.97
Prot margin 11.82
ROE 11.98
EPS $1.52
DPS 1.18
Book value per share 12.69
Stock price (12/31/96) 20.00
P/E with current price 13.16
Market/Book with current price 1.58
Intrinsic value of stock $16.55
1
P/E with intrinsic price 10.89
Market/Book 1.30
Payout ratio 77.63%
Westerns bond rating A
Westerns business risk category Average
1
The intrinsic value is managements estimate of the stocks equilibrium value. Management thinks investors are too
optimistic regarding future earnings, dividends, and the growth rate, and that when reports come out in the future, the stock
price will revert to the equilibrium level. Of course, not everyone in management shares this belief.
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TABLE 4
Selected Information Related to The Western Company
1. The latest quote on Westerns most recently issued long-term, semiannual bond as reported
in the nancial press is as follows:
Bonds Cur Yld Vol Close Net Chg
WES 8.5s24 7.6 30 111.51 +
1
2
These bonds have 27 years remaining to maturity, but they can be called in 7 years at a
price of $1,070. Westerns bonds are rated A, as are those of both utility subsidiaries. The
unregulated subsidiarys bonds are rated BBB. The companies all have the same capital
structures (measured at book value), so the rating variations are due to perceived differences
in business risk.
2. Recent quotes on Westerns common and perpetual preferred stock were as follows:
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
25 17 Western WC 1.18 5.9 13.2 9660 20H 20 20 +1
1203 1081 Westpf WCpf 8.00 7.0 67 114 114 114 +H
The subsidiaries preferred stock is publicly traded, but inactive, and no recent quotes are
available.
3. Recent quotes on long-term Treasury bonds were as follows:
Coupon Maturity
Rate Mo./Yr Bid Asked Chg. Ask Yld.
10
3
4 Dec. 05 134:25 134:29 6.05
9
7
8 Dec. 15 140:04 140:06 1 6.31
6
7
8 Dec. 25 108:19 108:21 5 6.23
4. Quotes on treasury bills were as follows:
Days
Maturity to Mat. Bid Asked Chg. Ask Yld.
Feb. 28 90 5.26 5.24 +.02 5.38
Apr. 29 181 5.24 5.22 +.03 5.44
Aug. 19 265 5.18 5.16 +.02 5.44
5. Westerns federal-plus-state income tax rate is 40 percent.
6. Westerns current annual dividend rate, which is (D
0
), is $1.18. Investors expect the divi-
dend to be increased next year. Here are the earnings and dividends per share during the last
5 years:
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Year DPS EPS
1992 $0.99 $1.24
1993 1.05 1.35
1994 1.10 1.38
1995 1.14 1.45
1996 1.18 1.52
Some analysts expect the same rate of growth in the future as in the past; others seem to
expect it to decline as new competition enters the market, and still others think the company
will be able to invest successfully in unregulated ventures, increase the earned rate of return,
andboost the growth rate. Some of the less optimistic analysts also note that the recent
decline in interest rates may lead to lower allowed rates of return, which in turn could hold
down the earnings and dividend growth rates. The average of all published analysts long
run forecastswhich are typically for the next 5 yearsis a rate of about 3.5 percent, but
the range is from a low of 1.5 to a high of 6.3 percent. However, Tina Clark recently attended
a conference where a panel of leading utility analysts discussed growth rates, using Western
as an example. These analysts agreed that Westerns earnings and dividends will probably
grow at a rate of about 4.5 percent for the next 5 years, then the growth rate will increase to 5
percent for the next 5 years, and then the growth rate will increase to 5.5 percent which will
continue on into the indenite future. These analysts, who are extremely inuential in terms
of their effects on the stock price, were remarkably consistent in their opinions.
7. Market risk premiums have been estimated in several different ways.
a. Various analysts have estimated expected returns on each of the S&P 500 stocks, aver-
aged those returns to get an expected rate of return on the market, and then subtracted the
T-bond yield from the expected return on the market to obtain an estimate of the market
risk premium. The results vary somewhat over time, with the risk premium appearing to
be smaller when interest rates are high by historical standards and larger when rates are
historically low, but the average risk premium during a normal period is about 6 per-
centage points.
b. Security analysts have asked portfolio managers what risk premium they demand on a
given companys stock over its bonds. The results generally indicate a 46 percent pre-
mium above the companys bond yield.
c. Ibbotson Associates has found that, historically from 1926 through 1995, stocks have
provided returns that exceed the returns on corporate bonds by an average of 7.0 percent
and Tbonds by 7.4 percent.
8. Value Lines expected return on the market, k
M
, is 14 percent.
9. Westerns historical beta as measured by several analysts is 0.65. However, since the utility
industry is undergoing a transition from a monopoly to competition, some analysts question
whether or not the historical beta is a good reector of future risk.
10. The going interest rate on AA-rated long-term corporate bonds is 7.0 percent, on A-rated
bonds it is 7.5 percent, and on BBB-rated bonds it is 8.0 percent. These rates are quite
volatile.
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TABLE 4 (Continued)
Selected Information Related to The Western Company
11. Western is forecasting earnings of $640 million and depreciation of $520 million for 1997.
Unless the dividend policy is changed, about 78 percent of earnings will be paid out as
dividends.
12. Investors do not expect Western to issue new common stock in the foreseeable future
because internally generated funds plus debt supported by retained earnings should be suf-
cient to nance capital expenditures. Westerns investment bankers believe that if a new
issue of common stock were announced, investors would interpret this as a sign that things
looked badthat internally generated funds were forecasted by management to decline in
the future. This would have a negative impact on the stock price. This stock price pressure,
along with underwriting fees, are estimated to result in total otation costs of 30 percent. If
the current stock price already reected the expectation of new stock issuances, then the
otation cost would be much lower. Flotation costs for preferred stock amount to about 4
percent, or $4 per share of $100 par value preferred.
13. Several years ago the old CFO wrote a memo in which he stated that Westerns target capi-
tal structure calls for 45 percent long-term debt, 5 percent preferred stock, and 50 percent
common equity. However, he expressed uncertainty about whether the target should be
based on book or market values. The companys investment bankers suggested that the
focus should be on market values, but the accountant/consultants recommend book values
because they believe that most bond rating agencies, security analysts, and other corporate
executives focus on book values. Tina Clark is not sure if the old CFOs target capital struc-
ture was actually implemented. Note that the three subsidiaries are currently all nanced
with essentially the came capital structure.
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