WACC concepts
FINANCE 400 Journal of Business Case Studies – Third Quarter 2014 Volume 10, Number 3 Copyright by author(s); CC-BY 335 The Clute Institute Sugar Cane Refining And Processing Company: A Comprehensive Case In Measuring A Firm’s Cost Of Capital Denis O. Boudreaux, University of Louisiana at Lafayette, USA S. P. Rao, University of Louisiana at Lafayette, USA Praveen Das, University of Louisiana at Lafayette, USA ABSTRACT The Sugar Cane Refining and Processing Company is a comprehensive case illustrating how a firm’s financial manager should calculate the firm’s cost of capital. Senior level undergraduate and graduate corporate financial management courses cover advanced topics in cost of capital and applying the rate in capital budgeting. To cover this relevant topic in a single case, the invented or “armchair” approach is used. This case is completely contrived but is very educationally effective. Keywords: Cost of Capital; Required Rate of Return; Hurdle Rate for Capital Budgeting INTRODUCTION hat is a firm’s cost of capital? A firm’s cost of capital is precisely as its name implies. When a firm raises capital from its lenders and owners, both investors require a return on their investment. Debt investors (lenders) expect to be paid interest on their loans and equity investors require dividends or capital appreciation as their return. The measure of a firm’s cost of capital is critically important for the following reasons: 1. In order to understand causality or Positive Theory the calculation of the cost of capital has to be found under different capital structures or capital mixes so as to determine if capital structure influences the cost of capital. If a firm uses a 40% debt and 60% equity mix and has an overall cost of capital of 10% and an identical type firm uses a financing mix of 45% debt and 55% equity and has a total cost of capital of 10.5% then we may conclude that an increase of debt from 40% to 45% for this type of firm increases the firm’s overall cost of capital. 2. Maximizing the value of a firm requires that the cost of all inputs or expenses be minimized; this includes the financing of the firm. To advance or recommend a certain financial mix such as the use of a certain percentage of debt in the financing structure requires knowledge of the cost of capital (Normative Theory). To minimize the cost of financing, we must be able to measure it and empirically study this phenomenon. 3. Investment decisions involving fixed assets or what is most often referred to as capital budgeting are extremely important to the firm’s success, cash flows, risk and to a very large part, its market value (Bierman & Smidt, 1988). Many financial economists consider capital budgeting to be the most important decision involving the financial manager. Finance research has made major advances in theory that provide the tools to correctly evaluate capital investment decisions. These tools are taught in undergraduate and graduate finance classes (for an excellent reference book see Brigham & Gapenski, 2008). The estimate of the true increment cash flows and discounting those projected cash flows to present value at the appropriate required rate of return has proven to be the correct theoretical method to value a capital project (Woods & Randall, 1989). This process requires the financial manager to use a discount rate in the valuation process. The discount rate used in capital budgeting for a company’s normal or average risk project should be the company’s Weighted Average Cost of Capital W http://creativecommons.org/licenses/by/3.0/ http://www.cluteinstitute.com/ Journal of Business Case Studies – Third Quarter 2014 Volume 10, Number 3 Copyright by author(s); CC-BY 336 The Clute Institute (Beranek, 1977). If the project is more or less risky than the average company’s project risk, the WACC should be adjusted to capture the difference in risk. To do a proper capital budgeting analysis, the cost of capital is a prerequisite. THE CASE Patricia Hotard, the Chief Executive Officer of Sugar Cane Refining and Processing Company (SCRPC), picked up the telephone to call Jimmy Breez, the firm's financial manager. Breez had sent her an email earlier that morning suggesting that the capital budgeting committee should get together prior to the scheduled Investment Decision Committee meeting that is in one week to discuss how the SCRPC’s cost of capital should be computed. SCRPC began its operations over 50 years ago as a cane sugar refinery. Its first plant is located on the outskirts of a mid size city in south Louisiana in the heart of sugar cane farming. It was the first sugar refinery to locate in the heart of what was a newly developing sugar cane growing area, and it remains by far the largest processor in the region. For the first 30 years, SCRPC sold its processed sugar to soft drink bottlers and candy manufacturers at a very small profit margin. In the last twenty years, SCRPC decided to use some of the sugar to manufacturer its own finished good products. The firm added two production facilities that manufacture hard candy, mints, and cotton candy. Recently the firm added another refinery in western Louisiana to service the many cane farmers located in that region. Although a conglomerate acquired the company in the 1960’s, it continues to operate autonomously. In addition to the title of Chief Executive Officer of SCRPC, Patricia Hotard also serves as a vice-president of the parent conglomerate in charge of agricultural product operations. Hotard called Breez and listened to his reasons for the request. Breez told her last year, many of the executives and members of the board of the firm who are members of the Investment Decision Committee did not fully understand the concept of cost and capital and its application to capital budgeting. Breez believed that the committee did not use a required rate of return to analyze the projects but looked at the project’s payback period and its internal rate of return (IRR). He remembers the committee voting to implement a project with a short payback and an IRR of 9 percent one year and the very next year rejecting two projects with an IRR of over 11 percent but long payback periods. Breez believes the committee may have voted against some projects that could have added value to the company while voting for some projects that would not predict an adjusted positive Net Present Values. Breez cautioned that SCRPC’s market value had declined during the past year while its three main competitors actually increased in market value. Breez thought much of this poor performance was due to improperly measuring the firm’s cost of capital and making errors in selecting the best capital budgeting projects. "Your suggestion interests me," said Patricia, "I believe you should prepare a three to four hour seminar to educate our committee. I had a finance class in my MBA program and we covered capital budgeting and cost of capital but that was many years ago. I could use a refresher course. We will meet Thursday of next week and you can educate us about capital budgeting and cost of capital. Also, after the class, hopefully we will decide how we should establish a required return and which capital budgeting projects we will forward to corporate headquarters as our investments for next fiscal year.” Breez went to work preparing for his seminar next week and Investment Decision Committee meeting. He reviewed several finance textbooks that cover cost of capital and gathered the financial information needed (see exhibits). Breez found that the determination of a firm’s cost of capital should be a systematic process and include the following steps: Steps 1. To determine the cost of capital, first identify each component that makes up the firm’s long-term financing mixture. 2. Determine each individual component’s before tax and after tax cost. http://creativecommons.org/licenses/by/3.0/ http://www.cluteinstitute.com/ Journal of Business Case Studies – Third Quarter 2014 Volume 10, Number 3 Copyright by author(s); CC-BY 337 The Clute Institute 3. Determine the weights or contribution of each component to the firm’s capital structure and prepare a Cost of Capital Matrix. 4. Find the Break Point for Retained Earnings. APPLICATION OF STEPS Step 1 The first step is to identify the components that make up the long-term capital structure. In capital budgeting, any expected spontaneous changes in working capital appear in the estimate of the incremental cash flows. So to avoid a double-counting of these current asset and current liability accounts, they should not be included in the measure of a firm’s cost of capital. Short-term debts, such as notes payable (which are not generated spontaneously) are not included in the capital budgeting incremental cash flow. If notes are used to finance long-term assets and they are actually continuously renewed, then this debt should be included in the firm’s cost of capital estimate. If this short-term debt is used only as temporary financing to support cyclical or seasonal needs then it should not be included. Using short-term notes for permanent financing is quite risky and most firms attempt to avoid unnecessary risk. For most firms the relevant capital components for cost of capital are: 1. portion of short-term notes that is considered permanent financing; 2. all long-term debt; 3. all preferred stock; and 4. all common equity. STEP 2 Each component’s before tax and after tax cost is calculated. Debt If a firm is using short term notes to finance long-term investments, the interest rate that the firm would be charged for a new bank loan is the before tax rate component. The before rate would be multiplied by 1 minus the firm’s marginal tax to find the after tax rate. Most firms use commercial bonds for long-term debt financing. The calculation for the use of bonds for financing is found by finding the current required yield and adjusting this yield to reflect the true after tax cost of debt to the firm if it were to issue bonds today (adjust for floatation costs and taxes). Flotation costs normally run about 1 to 2% of the issue (private placement are even less). The tax adjustment is to multiply the before tax yield by 1 minus the tax rate. Preferred Stock Investors purchase preferred stock for its dividend. The dividend can be viewed as a perpetual cash flow. Why, the firm does not have to pay the dividend? The firm will make every effort to pay the dividend. If they fail to do so (1) they cannot pay common stock dividends; (2) the market will not like this action (it is