Procter and Gamble: Cost of

Capital

Details

Dated: 19 Feb, 1990

People
Mary Shiller
Ron Emory, President, Corpstrat

Boss reaction on cost of capital

Corpstrat
Consulting firm
Located in Washington D.C.
Successful since 1980
Provided high-quality analysis for a few large corporate clients

Issues

Large client wanted to enter household products and

compete with P&G detergents, soaps, cleansers, and
personal care
Cost of capital of the client not feasible due to..,
Highly diversified conglomerate unrelated business
Overall WACC not useful for existing subsidiaries
Overall WACC not useful for new business consumer products

CFO had estimated his own WACC

CFO wanted to verify his WACC estimate
Corpostrat has been never asked to compute WACC of
clients

P&G
Detergent

and Soap giant

Dominant player in household products and
consumer goods markets

Corpostrat
Expertise:

defining and evaluating goals of a

corporation

Analysis of P&G Cost of Capital

Assumptions
WACC is a market value concept market value weights, current
market rate of return
Management makes investment decision with the goal of
maximizing wealth of investors
WACC is minimum rate of return that adequately compensates
the companys investors for the risk of investing in company
Projects IRR should be more than WACC
Bond and stock market are reasonably efficient
ESOP and capital structure changes are not relevant to the
calculation of companys WACC

P&Gs Business Risk

Expected annual revenues (1990): ~$23.5 bn

Popular brands: Tide, Cheer, Bold, Ivory, Zest, and Coast
Other products..,

Head and Shoulder Shampoo

Scope mouthwash
Bounty paper towels
Luvs disposable diapers
Crisco Shortening
Pringles potato chips
Folgers coffee
Dramamine for motion sickness
Vicks cough drops
Wood pulp and animal-feed ingredients

P&Gs Business Risk

Corporate sales distribution..,

Personal care and food & beverages segments have risks that are
similar to those of the laundry-and-cleaning products segments
Distributes all its products through..,

Laundry and cleaning products: 32.5%

Personal-care products: 45.7%
Food and beverages: 13.8%
Pulp and chemicals: 8.1%

Grocery stores
Retail outlets Krogers, K-Mart, Wal Mart

Soaps, detergents, toothpaste, peanuts, butter, etc., - small ticket

items on average homemakers shopping list

Relatively insensitive to swings in the economy

P&Gs Business Risk

Pulp and Chemicals..,

Sold directly or through jobbers
Had profit margins about double that of personal-care and
laundry-and-cleaning products groups
Made up of 8.1% of 1989 sales
Industrial product segments seems to be the only business
segment that is of sufficiently different risk to merit having a
different cost of capital
Small influence of this segment can safely be ignored in the
calculations

F&B segment broken even over past three years

Cost of Debt

Cost of refunding the debt on the companys books

Relevant debt: interest-bearing debt on the books as of
the end of FY1989: $3,331 million
Privately placed debt, no public price information
available
Traded coupon issue: 8.25% at a market price of $92.50
YTM: 9.18% very close to Aaa bonds of 9.22%
9.18% is very close to average coupon rate of the dollar
denominated debt on P&Gs books

Cost of Equity and CAPM

Recent beta estimate: 0.95

Rf rate?
Risk premium?
Equity risk premium (1926-1988)

Common stocks Bonds

GM: 5.4%
AM: 7.6%

Common stocks Bills

GM: 6.2%
AM: 8.4%

WACC
Ke

= 0.0847 + 0.95 * 0.054 = 13.6%

Corporate tax rate: 34%
Target D/V ratio: 35%
WACC = 0.35*9.2%*(1-0.34) + 0.65*13.6% =
11%

Response to P&G WACC

P&G has a dominant market share client is a new entrants

Competitors that can be included in analysis Clorox, ColgatePalmolive, and Church & Dwight
Compare Cloroxs WACC to P&G WACC
Clorox is small in size to match the new entrants
Expected return on bond is..,

Average yield = Coupon / Average price = 8.25% / ((92.5 + 100)/2) = 8.57%

Average gain = (Par Price) / Years to maturity = (100 92.5) / 15 = $0.50
Average percentage gain = Average gain / Average price = $0.50 / ((92.5
+100)/2) = 0.52%
Total return = Yield + gain = 8.57% + 0.52% = 9.09%

Response to P&G WACC

Ke = should use DDM growth and earning capitalization models

Cost of debt financed expansion is 9.2% but cost of equity is
13.6%
Funds are already available
Fund = RE and ST bank loans @ prime rate
Cost of RE?
Use IRR
Corox has higher proportion of equity than P&G
Corox has no publicly traded bonds can use P&G bond

Discussion Question

WACC comparable?

Cloroxs Business Risk

Specializes in detergents and cleansers

Clorox bleach
Liquid-Plumer
Soft Scrub
Formula 409

Produces other products lines as well

Kingsford
Match light Charcoal
Hidden Valley Ranch Salad dressings
Fresh step cat litter
Small % of Cloroxs sales some from Olympic and Lucitic paint brands

Cloroxs Business Risk

Markets

are mature
Most of the growth is through acquisition
1986 entered water market acquiring Aspen
Water, Deep Rock Water, and Acqua Pure
Water

Discussion Question

Does looking at companies other than P&G make

sense? Why?

Discussion Question

Is Mr. Emorys method for computing YTM

correct?

Discussion Question

Are the other cost of equity methods as good as

CAPM?

Discussion Question

Should the company compute the cost of RE as

part of cost of capital?

Discussion Question

Is anything lost if Ms. Shillers recommendation is

written in terms of IRR rather than NPV?

Discussion Question

Since Clorox is more conservatively financed

than P&G, do you expect its WACC to be
greater or less than P&Gs? Why?

Discussion Question

Based on your assessment of Mr. Emorys Suggestions,

what is your estimate of P&Gs WACC? Carefully state
all the assumptions used in your analysis

Discussion Question

What is Cloroxs cost of capital?

Discussion Question

What is CORPSTRATs objective in this

situation?

Need for P&Gs WACC

Clorox

is a highly diversified company

Different business risk = different required rate
of return

Discussion Question

What do you like and dislike about Mr. Emorys

suggestions for Ms. Shiller?

Emorys Memo
Firm

size and market share influences

business risk
Suitability of Clorox
Simple

capital structure
Reasonably good business risk match

Colgate

= has preferred stock

Depending on more than one companys
WACC makes sense

Emorys Memo

Emorys methods of estimating YTM is close but not

exact
YTM = average yield + average capital gain
Ignores time value of money
Equals YTM when current market price equals par value

YTM is an upwardly biased estimate of cost of debt

Bias results because the cash flows discounted are the
contracted cash flows rather than expected cash flows
Junk bond yield = represents maximum possible return
for the investor rather than the expected return

Emorys Memo

Important to check robustness of CAPM

RE can be matched with cost of equity
Higher P&G financial risk will makes its cost of equity
higher than Clorox
Market value of debt / total capital = 3,331 / (3,331 +
126.25 x 169) = 15.6%
WACC = 0.156 (9.2%)(1-0.34) + 0.844 * 13.6% = 12.6%
1.6% more than Mary Shillors book-value based WACC

Emorys Memo
AM

may be used because..,

CAPM

is a single period model = AM and TBill

Can incorporate markets LT expectations of inflation = AM
+ Treasury Bond

GM

may be used because..,

WACC

is compared to IRR which is compound or

geometric return
YTM is a geometric return

Discussion Question

What is P&Gs cost of Debt? Cost of Equity?

WACC?

Discussion Question

What is Cloroxs WACC? Why does it differ from

P&Gs?

Discussion Question

Why is cost of capital important to corporations?

Alternative to Cost of Equity (DDM)

Dividend Growth Model

LT growth rate estimate..,

1989 dividend yield = $3.00 / $126.25 = 2.38%

Historical DPS (1980-1989): 6.5%
Historical EPS (1980-1989): 7.0%
Value line projections of Dividend growth: 11%
Value line projections of earning growth: 15.5%

Using growth in EPS of 15.5% + 2.38% yield implies a cost of

equity of 18%
With average EPS and growth in DPS, cost of equity will be
15.65%

Alternative to Cost of Equity (Earnings

Capitalization Model)
Cost

of equity = inverse of P/E ratio

Will be reasonable estimate only under
unusual circumstances
1989 EPS = $7.12
Share price as on 23rd Feb 1990: $126.25
E/P = 7.12 / 126.25 = 5.6%
Its less than cost of debt

Cloroxs WACC

Total interest bearing debt = commercial paper + current

maturities of LT debt + LT debt and other obligations

Given the predominance of ST obligations, book value is a

close approximation to market value of debt
Market value of equity = price per share x no. of outstanding
shares

= $79,580 + $14,658 + $7,051 = $101,289

= $38.25 x 55 million shares = $2,104 million

Debt = 4.5%
Equity = 95.4%
Value line beta: 0.90

Cloroxs WACC
CAPM

Ke = 0.0847 + 0.90*0.054 = 13.3%

DDM ke..,
Dividend

yield = $1.09 / $38.25 = 2.85%

LT growth estimate

DDM

Historical DPS (1980-1989): 12.1%

Historical EPS (1980-1989): 13.4%
Value line projections of Dividend growth: 13.5%
Value line projections of earning growth: 15.5%

Ke = range from 14% to 16.5%

Cloroxs WACC
Earnings
1989

Capitalization Model

EPS: $2.24
23rd Feb 1990 share price: $38.50
Ke = 2.24/38.25 = 5.9%
Ke is less than cost of debt

Cloroxs WACC
Average

Ke of CAPM and DDM = 14.9%

P&G cost of debt = 9.2%
WACC = 0.045(9.2%)(1-0.34) + 0.955*14.9% =
14.5%

Cloroxs WACC vs. P&Gs WACC

P&G

cost of funds could be lower because of

prudent use of tax-advantaged debt
Cloroxs conservative use of debt increased
WACC

Discussion Question

What is best debt structure for the new client?

Cloroxs 4.5%
P&Gs 15.6%

Discussion Question
How CORPOSTRAT should present its results to
the client?
Should it try to reconcile the difference or should
it just report the findings and let the client
interpret the result on its own?

Zero Coupon Bond YTM

Par value = 100

Years to maturity = 10
Market value = 50
Actual YTM = 7.05%
Average yield = coupon / average price = 0%
Average gain = (Par price)/year to maturity = (100-50)/10
= $5
Average percentage gain = average gain / average price =
5 / (50 + 100)/2 = 6.67%
Total return = yield + gain = 0% + 6.67% = 6.67%