Analysis using WACC

2. Analysis & Proposal – Weighted Average Cost of Capital
1 Summary
Weighted Average cost of capital (WACC) for Heinz had been a subject of controversy due to three main
reasons – Share price of Heinz for last three years, low interest rates in market and current financial melt-down.
The following report analyses these conditions and determines a WACC given the set of conditions provided.
2 Factors Effecting WACC
Various factors that affect the Weighted Average cost of capital (WACC) computation for Heinz are - Market
Risk Premium, Cost of Debt, Cost of Equity, and Heinz Risk relative to Market. In order to precisely estimate the
cost of capital we will present our thought process in computation of various factors.
2.1 Market Risk Premium Assumption
Our analysis took a long term approach and measured the average
market risk premium to be around 7.5%. However, when
measured over shorter time periods, this premium varied greatly
from 5% to 9%.
Market Risk
Premium
7.5%
2.2 Analysis of Cost of Equity
For determination of Beta (β) we used historical values from Jan
2001 till April 2010 of Heinz and Market, and found out the co-
relation between them using regression. We also analyzed the
company’s Beta using market data, where sources used only
previous five years as a comparison strategy.
Further, we used 10-year US government bonds as the risk-free
rate.
Using the above information we compute the Cost of Equity using
the following equation, Where R(e) is Cost of Equity, R(f) is risk
free rate and (E(Rm) –R(f)) is the value of market risk premium.
Further, we found that the cost of a share was $46.87. Thus, using this information and the number of
shares outstanding we have: Market Value of Common Equity = Price of one share x Number of shares
outstanding.
Market Value of Common Equity 46.87 X 317690000
=14890130300
Beta ( 10 years of data) 0.441
Beta (Market Sources) 0.62
R (f) 0.369
Cost of Equity (using computed Beta) Cost of Equity (Market value of Beta)
0.0834 0.069975

3. 2.3 Analysis of Cost of Debt
Our analysis assumed that the book value (from 10K) of short-
term debt is equal to the market value of short-term debt and the
book value (from 10K) of long-term debt is equal to the market
value of long-term debt.
During our analysis, we
looked into the market
data sources to
determine the yield and
coupon rates of our debt
for the year 2010.
We considered the
current portion of long
term debt, short term
debt and long term debt
to get the total debt.
3 Computation of WACC
In order to compute the WACC we used the marginal tax rate to 35% and Market Risk Premium as 7.5%.
Further WACC is the sum of cost of debt and cost of equity. The formula that we use for computing WACC is
WACC = R(d) (1- Tc )*( D / V )+ R(e) *( E / V )
Cost of Debt Cost of Equity WACC
WACC (beta 0.441) 0.006902331 0.063849672 0.060474
WACC (beta 0.62) 0.006902331 0.063849672 0.070752
4 Assumptions & Estimations
4.1 Standard Errors in Estimation
The estimation of the WACC is based on several key assumptions:
o It is market driven. It is the expected rate of return that the market requires to commit capital to an
investment.
o It is a function of the investment, not the investor.
o It is forward looking, based on expected returns.
o The base against which the WACC is measured is market value, not book value.
o It is usually measured in nominal terms, which includes expected inflation.
Long Term Debt 4559152
Short Term Debt 43853
Year Coupon Maturity Price Yield Book Value
of Debt
Book value of
Weighted Debt
2010 0.0675 3/15/2032 116.9 0.0453 4559152000 206529585.6
2010 6.625 10/15/2011 107.5 0.0041 43853 179.7973
Long term Debt 4559195853 0.045299604
Long term Debt 4559195853
Current portion of long term debt 15167
Short term Debt 43853
Total Debt 4559254873
Market Value
Cost of Debt R(d) 4559254873
Cost of Equity R(e) 14890130300
Total of Cost of Debt & Cost of Equity V 19449385173

4. o It is the link, called a discount rate, which equates expected future returns for the life of the
investment with the present value of the investment at a given date.
Precision on our estimation is based on the following assumptions made during – Calculation of Market Risk
Premium, Calculation of Beta and Calculation of risk free rate. We assumed a long term approach for the
Market risk premium and assumed the value to be 7.5%. We ran a regression on the data we had for the
returns of Heinz and the market from January 2001 to April 2010 to compute the Beta. The standard error
of the regression is 0.043, so we feel very confident given the data that our calculation of Beta represents
the long term relationship between the market return and the returns for Heinz.
We also calculated the WACC using market risk premiums ranging from 5% to 9% and using both the
computed beta and the beta from the market sources. We see the following results:
As we can see, by varying the risk premium and the beta, the WACC ranges from 5.2% to 7.78%. This is not
far from the calculation we have in 3 above.
4.2 Market Risk Premium Estimations
Market risk premium used by the analysis was based of a long term approach. While developing a plan for
long term, we used 7.5% as market risk premium, but we also analyzed how for a particular Beta, the WACC
changed with market risk premium. The WACC ranges between 6.55% and 5.2% by using different market
risk premiums. The value 7.5% is a good estimate because it lies in the middle of the spectrum. So, we can
say that we are neither being too aggressive, nor too conservative with that value. Our recommendation is
to use 7.5%
Beta =0.041 Beta = 0.62
Market risk
Premium
WACC Market risk
Premium
WACC
9% 6.554% 9% 7.787%
8% 6.216% 8% 7.313%
7.50% 6.047% 7.50% 7.075%
6% 5.541% 6% 6.363%
5% 5.203% 5% 5.889%
4.3 Government Bond Rates and risk free rate
The financial crisis and aggressive federal government actions have caused the Government bond rates to
be unusually low. However, they have also caused the inflation rate to be low. When thinking about the
bond rates, it’s important to look at the real rates, not the nominal rates. Therefore, we feel that there is no
need to adjust the risk free rate to reflect these conditions.
Market risk Premium Beta Cost of Debt Cost of Equity WACC
9% 0.441 0.0069 0.0586 6.554%
9% 0.62 0.0069 0.0710 7.787%
8% 0.441 0.0069 0.0553 6.216%
8% 0.62 0.0069 0.0662 7.313%
7.50% 0.441 0.0069 0.0536 6.047%
7.50% 0.62 0.0069 0.0638 7.075%
6% 0.441 0.0069 0.0485 5.541%
6% 0.62 0.0069 0.0567 6.363%
5% 0.441 0.0069 0.0451 5.203%
5% 0.62 0.0069 0.0520 5.889%