Estimating The Cost Of Capital In Uncertain Times Case Solution

Introduction

Heinz started its operations in 1869 in the North America and gradually grew into a well-known Food Company. Heinz company deals in three product categories i.e., sauces and ketchup, snacks and meals and infant nutrition. It operates in more than 200 countries. Heinz is divided in different business segments based on regions, which are composed of North American Consumer Products, U.S Food services, Europe, Asia and other countries in the world. The biggest competitor of Heinz are Kraft Foods, Campbell Soup, Del Monte, Nestle and Unilever. The strategy of the company is to become the market leader in the food industry and provide the best quality food to their consumers.(H.J.Heinz: Estimating the Cost of Capital in Uncertain Times, 2013). The company is focusing to increasing the potential performance of the recent products, and to introduce the new products and generate an attractive cash flow for the company. The recent down turn in the market has made the financial analysis to be more concentrated to determine their WACC and the trend effected on the WACC. The WACC was effected by the market crisis,which was declining in the interest rate,causing high volatility in the stock price of the company and the recent financialme lt down.

Critical Analysis

Heinz’s WACC

The Heinz’s WACC is 6.71%, which is comprised of 46% debt in the capital structure, and 54% equity in the capital structure. Although the cost of equity (ke) and the cost of debt (kd) in the WACC of Heinz during 2010 are 8.57% and 7% respectively.(Booth, Cleary,, & Drake, 2013)

The cost of equity is calculated by using a CAPM (Capital Asset Pricing Model) which determines the relationship between the rate of return and the systematic risk, which is also known as market risk and nom diversifiable risk.

In the first part of CAPM risk free rate (RF) is taken, which is the rate that has no financial risk or no loss over investment. The risk free rate of Heinz’s is 3.69%, which is taken from the average historical yield of 10 years mentioned in the exhibit-3 in case. The next part of the CAPM shows the beta that indicates the systematic risk associated with the investment. The market beta is always 1. If the investment is composed of more risky assets then the beta is greater than one and vice versa. The beta of Heinz’s is .62 as given in the case (pg#2), which shows that the investment is diversified between the moderate risky assets.

In the next part, beta is multiplied by the market risk premium, which indicates the difference between the risk free rates. The market risk is the maximum risk associated with the investment and by subtracting the risk free rate which is the minimum risk or the zero risk, the average risk is derived. The reason of multiplying the beta is that if the investment is done in high risky assets then the consumers demand high return and vice versa. The average market premium is 7.50% as given in the case.(pg#2).

Cost of debt is composed of two types of debt i.e.long term debt and short term debt as mentioned in the balance sheet of the company. Cost of debt is derived after subtracting the tax rate which is computed by dividing the income tax of 2010 to the earning before tax (EBT). The tax rate is 28% on the firm revenues. Interest is calculated on assumption basis as two different maturity bonds are mentioned in the company’s balance sheet.

Competitors’ WACC:

Kraft’s WACC:

The Kraft’s WACC is 6.21% which is comprised of 42% debt in the capital structure and 58% equity in the capital structure. Although the cost of equity and the cost of debt in the Kraft’s WACC  during 2010 are 8.04% and 5.12% respectively. The cost of equity is calculated by using a CAPM (Capital Asset Pricing Model) in which beta is given in exhibit-4 (pg#8) as .58. The risk free rate and the average market premium are same as 3.69% and 7.5% respectively.

Campbell’s WACC:

The Campbell’s WACC is 3.79%,which is comprised of 78% debt in the capital structure and 22% equity in the capital structure. Although the cost of equity and the cost of debt after tax in the Campbell’s WACC during 2010 are 6.09% and 3% respectively. The cost of equity is calculated by using a CAPM (Capital Asset Pricing Model) in which beta given in exhibit-4 (pg#8) is .32, which shows that company has low risk portfolio. The risk free rate and the average market premium are 3.69% and 7.5% respectively.

Del Monte’s WACC:

The Del Monte’s WACC is 7.18% which comprises of 41% debt in the capital structure and 59% equity in the capital structure. Although the cost of equity and the cost of debt after tax in the Del Monte’s WACC during 2010 are 9.09% and 4% respectively. The cost of equity is calculated by using a CAPM (Capital Asset Pricing Model) in which beta  given in exhibit-4 (pg#8) is .72. The risk free rate and the average market premium are 3.69% and 7.5% respectively………..

 

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