H J Heinz: Estimating the cost of capital Case Solution

The yields on the two (2) outstanding debt issues as at the end of April 2010:

The YTM method estimates the before-tax cost of debt based on the bond price and the present value of annuity calculation. YTM is an appropriate estimate of the long-term cost of debt as it measures the rate of return paid to bondholders if the bond is held until maturity.

Coupon2032 Issue 3.38% 2010 2009
Coupon flows           3.95           3.08
Price 2010 $116.90
Price 2009  $       91.40
Yield   8.4% 9.0%
YTM Calculation Based on Cash Flows
2012 Issue
Coupon 3.31% 2010 2009
Coupon flows           3.77           3.86
Price 2010 $113.70
Price 2009  $    116.50
Yield   3.31% 3.31%

 Analysis

The analysis is made into various factors affecting the weighted average cost of capital for the company. Information was given in the case that it will be used in estimating the WACC as well as evaluating WACC by taking other variable factors into consideration.

Weighted Average Cost of Capital-WACC

Cost of Equity

In order to estimate the cost of capital, cost of equity needs to be estimated first. As per the case, the market risk premium is estimated to be 7.5% or 6% or even 5%., however the market risk premium has been taken as 7.5%. This is because this risk premium is taken based on longer term period rather than short term risk indicator, which is 6%. If lower risk premium is taken, then this might be considered as a bias in evaluating investment projects.

The case has less data on the beta calculation therefore, the industry comparable information has been used for estimating the beta to calculate the cost of equity. The average beta is estimated to be 0.63, as shown in excel. The 10 year yield on bond is taken as risk free rate, which is 3.69%. The cost of equity is calculated using the CAPM model, which is:

Cost of Equity= Risk Free rate + beta*Market risk premium

Cost of Debt

The cost of debt has been estimated using the bond information given in the exhibit 3. The average of the bond rates was taken as the cost of debt, which is estimated to be 6.69%.

Long-Term Debt Rate
Bonds 1 6.75%
Bonds 2 6.63%
Average 6.69%

 Weighted Average Cost of Capital

The weighted average cost of capital for the company has been estimated using the information calculated as per case information available. The tax rate is estimated using the income statement of the company. Tax rate is averaged to 28% in 2009 and 2010. The weighted average cost of capital is calculated using the formula:

WACC = * Re + * Rd * (1 – Tc)

Where,

  • Re = cost of equity
  • Rd = cost of debt
  • E = market value of the firm’s equity
  • D = market value of the firm’s debt
  • V = E + D
  • E/V = percentage of financing that is equity
  • D/V = percentage of financing that is debt
  • Tc = corporate tax rate

Or simply,

WACC= (Cost of Equity*Weight of Equity) + (Cost of Debt*Weight of Debt)*(1-Tax Rate)

The WACC for Heinz in 2009 and 2010 respectively:…………………..

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