Cost of Capital
Cost of Capital
To complete this assignment, you must estimate a cost of capital for your company. Please submit a spreadsheet with all your calculations clearly indicated. There are many steps required as described below.
1. Check to see if your company (Pepsi Company) is rated by Moody’s by going to their website. (Registration required.) Another less focused approach is to just type in the name of the company and “bond rating” in a Google search and see what comes up.
2. Estimate a synthetic rating for your company.
a. For firms without a rating, this will be your primary basis for estimating the cost of debt. For firms with an actual rating, it will give you a basis for comparison. You can continue to use the actual rating, but be aware of the synthetic rating as well.
b. You can use the Synthetic Rating spreadsheet to do the computation, or you can do it by hand.
c. You will need some data for this:
i. Get the raw data on interest bearing debt: In particular, take a look at the balance sheet and identify the interest-bearing debt. Include bank loans and corporate bonds, short term and long-term debt. Don’t include things like accrued income tax. For ambiguous items, such as “long term liabilities”, you will have to make the judgment. Read the notes to the financial statements and decide whether it meets the definition of debt we discussed in class. (It is possible that your firm has no debt. Don’t pull your hair out looking for something that does not exist. A clue that your firm has no debt will be in your income statement if your interest expenses are zero).
ii. Collect operating lease data: For US companies, the lease commitments (if any) should be in a footnote in your financial statements. The current year’s lease payment will also be reported close by. Again, note that not all companies have lease commitments.
3. Convert your bond rating (either actual or synthetic) to a pre-tax cost of debt.
Market Value of Debt and Equity
1. Estimate the market value of the debt of your firm (including off-balance sheet debt).
a. For interest bearing debt in part 2, estimate the average time until the debt is due (the “maturity” of the debt) and then pretend that the debt is a coupon bond with a coupon payment equal to the current interest expense and a face value equal to the book value of the debt. Use the cost of debt to calculate a present value.
b. For lease commitments, calculate the present value of the future lease commitments, again at the cost of debt.
c. If your firm has other long-term commitments noted in the annual report, include those as well. (For example, Netflix’s content agreements require future payments with a present value of over 20% of the value of the company.)
2. Estimate the market value of the equity of your company. (Look at the market price per share and the number of shares outstanding.) If your company has multiple share classes, be sure to include the total value of all of them. If your company has large amounts of employee stock options or convertible debt, see me.
1. Get a marginal tax rate to use on your cost of debt. In the US, this is currently 21%. In other countries, the number is lower. See the kpmg.com link I provided on Blackboard.
Cost of Equity
1. Start with the unlevered beta you estimated in the previous homework.
2. Compute the levered bottom-up beta for your firm. (You estimated all the other pieces earlier in this homework.
3. Get an estimate of the risk-free rate.
4. Estimate the Market Risk Premium. (If your company operates internationally, this might contain an adjustment for emerging market risk.)
5. Estimate the cost of equity.
Cost of Capital
1. Estimate the cost of capital for your firm. (If your firm has preferred stock, you should deal with it as well. It will not take long; see me for details.)