DE LA SALLE UNIVERSITY

Graduate School of Business

Case Analysis:
Zagat

In partial fulfillment of the course requirement for

Managerial Statistics

Submitted by:
Aisabelle Coloma
Hesberto Concepcion
Jedidiah de Gracia
Fritzie Mendenilla
Ren Tongco

Submitted to:
Prof. Ed Montesclaros

January 31, 2008

GROUP 5
CASE 102 AUTO HUT, INC.

Executive Summary
Based on our analysis the group recommends recalculation of the required return of Auto Hut
using the following the costs of capital (ACA 2):

1. Cost of Debt 4.8%

2. Cost of Preferred 6.51%
3. Overall Cost of Common Equity (CAPM) 13.11%

To compute for the Weighted Average Cost of Capital of the firm, we used the investment
banker’s suggested capital structure, 30% long-term debt, 5% preferred stock, and 65% common
equity along with the costs we have computed in ACA 2. By combining the cost of capital for each
of the capital components of the firm and multiplying it to a target capital structure, defined as that
mix of debt, preferred, and common equity that will maximize the firm’s stock price, we got for us
the weighted average cost of capital. Which means, each dollar that the firm raises will consist of
some long-term debt, some preferred stock, and some common equity, and the cost of the entire
dollar will be the weighted average cost of capital

WACC = Wd x Kd (1-T) + Wp x Kp + Wc x Ks
WACC = 30% x 4.8% + 5% x 6.51% + 65% x 13.11%
WACC = 10.29%

The after tax cost of debt is only 4.8%; the cheapest cost among other capital components,
hence, should Auto Hut change its capital structure by using more bonds than common equity
and/or preferred stock to finance acquisitions, they will be able to reduce their WACC. However,
considering that their total debt to total assets ratio of 59% is over the industry average 56% and
their debt equity ratio is already very high at 1.44.

Autohut may only issue so much debt papers since its present outstanding bonds are secured by
a first mortgage. Once the maximum allowable value of Autohut’s assets for security is reach,
the management of the company can no longer raise capital by borrowing. Given that its debt
equity ratio is already high, the group recommends that Auto Hut should try to finance
acquisitions more through preferred stock since the cost of preferred stock is the second lowest
costs at only 6.51%. In addition, the company can also invest their retained earnings up to USD
51 mio in the new investment to avoid the 30% flotation costs associated in issuing common
stocks and can reduce their debt equity ratio up to 1.12 as well as debt to total assets ratio of up
to 53%.
GROUP 5
CASE 102 AUTO HUT, INC.

I. Statement of the Problem:

What is the best approach that represents the firm’s “true” cost of capital and capital structure that
will aid management in making capital budgeting decisions maximizing shareholders’ value?

II. Background of the Case:

In 1986, Jack Cahill formed Auto Hut, Inc through a “purchase money mortgage” to be repaid
from the business’ cash flow. Together with borrowings from friends and bank loans totaling to
$300,000. he purchased computers and softwares, and trained his employees to use the new
equipment for the business. Profits rose rapidly than what he forecasted that within a year, he
began to look for additional acquisitions. He took over two new shops in 1987 and another three
more in 1988. Acquisitions continued at an increasing pace, and by 2002, Auto Hut owned a total
of 243 shops located throughout theMidwest

Since the inception, Jack has been involved in all facets of the business except for the for the
company’s financial management,as this is the area in which he has no special expertise. The
recently retired controller had been responsible for most of the financial matters. In late 2001, to
ensure continued success, Jack hired Mike Walinski, as Vice President and CFO. He evaluated
Auto Hut’s capital investment and expenditure decisions. He reviewed the financial information
and questioned the cost of capital estimates as follows:
• Retired controller used a before-tax debt cost of 10% equal to the 1999 coupon rate long term
first BBB mortgage bond issue which will be mature in 17 years and can be called after 3
years.
• Retired controller used the year-end “earnings yield” of 7.5% since the company will only sell
stock for finance projects that would earn more than 7.5% cost of equity.

III. Assumptions of the Case:

⇒ 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
⇒ Auto Hut’s historical beta as measured by several analysis is 1.3
⇒ Auto Hut is forecasting 2002 earnings after preferred dividends of $34,254,000 and
depreciation of $9,000,000
⇒ Management expects to pay out 20 percent of earnings as dividends
⇒ A new issue of common stock would require flotation costs of as much as 30 percent.
⇒ Autohut’s federal plus state tax rate is 40 percent
⇒ Auto Hut has outstanding 7 percent, annual payment, $100 par value, perpetual preferred
stock, which closed at a price of $105 per share. The firm’s investment bankers said 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 stocks would be $2.50 per share.
⇒ Investment bankers suggested that the company’s capital structure should consist of 30
percent long-term debt, 5 percent preferred stock, and 65 percent common equity.
⇒ The consulting firm is using a 5 percentage point market risk premium for stocks over 10-
year Treasury bonds.
⇒ Year-end 2001, retired controller used a before-tax debt cost of 10 percent, which was
equal to the coupon rate (1999) long –term first mortgage bond issue. The bonds are
rated BBB, will mature in 17 years and can be called after 3 years.
GROUP 5
CASE 102 AUTO HUT, INC.
⇒ The retired controller used the year-end “earnings yield” (EPS/Price) of 7.5%, well below
the interest rate on debt. He explained that since the company will only sell stock for
finance projects that would earn more than 7.5% cost of equity, capital budgeting would
yield to higher earnings per share

Objectives of the case:

1. To determine if the current approach in estimating cost of capital properly takes into
account all the necessary measures of performance

2. To evaluate and project the firm’s cost of capital

3. To present to management the best approach in calculating the firm’s cost of capital

ACAs:

1. Reliance on the Controller’s Computations:

Capital
Components Balance Weights (current)
L T Bonds 80,000,000 80,000,000 31%
Preferred Stock 20,000,000 8%
Common Stock 40,000,000
Retained Earnings 118,594,000 158,594,000 61%
258,594,000 100%

Retired Controller’s Weighted Average Cost of Capital (WACC) Computation

WACC
Investment Investment
Capital Weights Banker's Cost of WACC Banker's
Components Balance (current) suggestion Capital (current) suggestion
L T Bonds 80,000,000 31% 30% 10% 3.09% 3.00%
Preferred Stock 20,000,000 8% 5% 7% 0.54% 0.35%
Common Stock
Retained Earnings 158,594,000 61% 65% 8% 4.60% 4.88%
258,594,000 100% 100% 8.23% 8.23%

2. Recompute the overall required return of the company using the ff:

OVERALL COST OF COMMON EQUITY( CAPM)

Ks = 6.61% + (5%)(1.3)

= 13.11%

The grouped used the yield (6.61%) of a long term bond that will mature on Dec 2019 to match
the project’s long term tenure. This follows the market risk premium for stocks over 10 year
GROUP 5
CASE 102 AUTO HUT, INC.
Treasury bonds. We did not use the risk premium as concluded by Ibbotson Associates as we
prefer to employ the ex ante approach or forward over ex post approach or backward looking to
allow the change in the risk premium over time.

To test the validity of the above, we also performed the Bond-Yield-Plus-Risk-Premium

Approach where we simply get the YTM of the long term bonds and add the risk premium for
stocks of the long term bond used in above.

Ks = bond yield + risk premium

= 8% + 5%

= 13%

COST DEBT

YTM (Yield to maturity)

No. of semiann. periods (N) 40
Bond price (PV) $1,198
Semiann. coupon pymts $50
Maturity value (FV) $1,000
YTM = 8.00%

After tax cost of Debt, Kd = Cost of New Debt (1-Tax)

20 year BBB rated bonds

Par Value 1,000
Coupon rate (semiannual) 5%
PV of Bonds* 1,198
Call Price 1,100
Years to Maturity 20
Years to Call 3
Yield to Maturity 8%
*Present value of the 20 year BBB rated bonds using 8% as discount factor

Kd = 8% (1-40%)

Kd = 4.8%

The group used the YTM (8%) of the new long term bonds since we are interested in the marginal
cost of debt for capital budgeting decisions. Hence, we disregarded the cost of the outstanding
long-term bonds in the balance sheet. The group also considered the tax savings generated from
incurring interest expense to get the after tax cost of debt. The value of the firm’s stocks depend
on the after-tax cash flows.

COST OF PREFERRED

Formula: Kp = Dp / (Pp - F)

Kp = $6.67 / ($105-$2.5)
GROUP 5
CASE 102 AUTO HUT, INC.

Kp = 6.51%

In computing the cost of preferred, the group considered the following values:

a. $6.67 – new coupon dividend per preferred share

b. $105 – market value per share
c. $2.50 – flotation costs associated in issuing new shares

DIVIDEND YIELD PLUS GROWTH RATE FORMULA OR DISCOUNTED CASH FLOW

APPROACH OR COST OF RETAINED EARNINGS

Since ranges of growth rates were given in different periods, the group decided to get the cost of
capital using the following analysts’ forecast:

a. Average growth rates: 20% - 1 to 3 years; 15% - 4 to 6 years; Starting a $0.46 dividends
per share in 2001.

Dividend Cash Flows

Growth rate of 20% Growth rate of 15% 11% Terminal
Value
2002 2003 2004 2005 2006 2007 2008
Dividends price per
share $0.55 $0.66 $0.79 $0.91 $1.05 $1.21 $1.34 $57.74
Terminal Value $57.74
Total $0.55 $0.66 $0.79 $0.91 $1.05 $58.95

Then, based on the current market price net of flotation cost of the stocks which is $21.35 which
we used as a NPV to work back with the dividend cash flows from 2002 to 2007 and we arrived at

Ks = 14.30%

b. Dividend growth rates: 20% - 2002; Declining for 15 years; stabilize at 10%.

Our group computed the average declining rate which is (20% - 10%)/15 = .67%.

End of Year Growth rate

2001 0 $0.460 $0.46
2002 1 20.00% $0.552 $0.55
2003 2 19.33% $0.659 $0.66
2004 3 18.67% $0.782 $0.78
2005 4 18.00% $0.922 $0.92
2006 5 17.33% $1.082 $1.08
2007 6 16.67% $1.263 $1.26
2008 7 16.00% $1.465 $1.46
2009 8 15.33% $1.689 $1.69
2010 9 14.67% $1.937 $1.94
2011 10 14.00% $2.208 $2.21
2012 11 13.33% $2.503 $2.50
2013 12 12.67% $2.820 $2.82
 GROUP 5
CASE 102 AUTO HUT, INC.
2014 13 12.00% $3.158 $3.16
2015 14 11.33% $3.516 $3.52
2016 15 10.67% $3.891 $3.89
2017 16 10.00% $4.280 $154.84
2018 17 10.00% $4.708

Then, based on the current market price net of flotation cost of the stocks which is $21.35 which
we used as a NPV to work back with the dividend cash flows from 2002 to 2007 and we arrived at

Ks = 14.36%

In getting the cost of capital to be used in WACC computation, the group decided to average the
two results to obtain the most reasonable figure which is 14.33%.

It can also be seen that there is a difference if you between the required rate of return (KRF + RF =
11.61%) and the DCF because it can be assume that the market is in disequilibrium. Also, since
the growth rate used is not constant in the future, the group cannot consider this in computation
of WACC, hence, we will consider the cost of equity from CAPM.

In computing for the revised WACC, the target proportions of debt, preffered stock and common
equity, along with the costs of these components, are used to calculate the weighted average
cost of capital, WACC.

REVISED WACC COMPUTATIONS:

Retired Controller Group's computation

WACC WACC
Investment Investment Investment Investment
Weights Banker's Cost of WACC Banker's Banker's Cost of WACC Banker's
(current) suggestion Capital (current) suggestion suggestion Capital (current) suggestion
L T Bonds 31% 30% 10% 3.09% 3.00% 30% 4.80% 1.48% 1.44%
Preferred Stock 8% 5% 7% 0.54% 0.35% 5% 6.51% 0.50% 0.33%
Common Stock
Retained
Earnings 61% 65% 8% 4.60% 4.88% 65% 13.11% 8.04% 8.52%
100% 100% 8.23% 8.23% 100% 10.03% 10.29%