H.J. Heinz Company Case:
Cost of Capital in Times of Uncertainty
Alan Ho 20349978
Saraniya Paramanathan 20332829
Christopher Abeleda 20335744
Nathanael Cheung 20345672
Reuban Nadesan 20346511
To: Board of Directors Committee, H.J. Heinz Company
From: Group 10 Consulting
Date: July 7, 2011
Subject: Weighted Average Cost of Capital Recommendation
Heinz has reached an unstable point in its business cycle and must calculate an appropriate cost of capital during these uncertain times. The cost of capital is an essential measure in determining the cost ...view middle of the document...
The cost of equity is more subjective because there is no explicit return required on equity. Please refer to Appendix 2 for other considerations for cost of equity calculations. Most firms use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The components that make up the CAPM include: the risk free rate, the beta of the security, and the expected market return of the stock. These values are all based on forward-looking data. The model dictates that shareholders require a return equal to the return from a risk-free investment plus an equity risk premium for bearing extra risk. Refer to Appendix 1 for a full breakdown of the CAPM formula.
The risk-free rate recommended under the CAPM model is the yield on long-term (i.e. 10+ years) T-bills. When choosing the T-bill term, it is important for it to closely represent the time frame used for Heinz’ required rate of return.
A common practice to determine the firm’s beta is to draw from historical data from published sources or compare numbers to competitors. In this case, Heinz can compare to Kraft, Campbell Soup and Del Monte and use professional judgement in determining the stock’s sensitivity to the market. A stock’s beta can be determined using a formula as well.
As mentioned earlier, the theory uses a forward-looking risk premium which reflects current market conditions that are sensitive to changes. Although this is the case, research on various companies demonstrates that experts infer future expectations for the market premium based on historical data. The article Best Practices in Estimating the Cost of Capital: An Update states that it is also recommended to calculate this component over a longer period of time as it would produce a more stabilized measure for the company.
2.0 Yield-To-Maturity and Cost of Debt (Fiscal Year 2009 and 2010)
To determine the yield on the two representative outstanding Heinz debt issues as of the end of April 2010, many factors were taken into consideration. Please refer to Appendix 4 for calculations.
The first bond that Sheppard considered representative of the company’s outstanding borrowings was a note due in 2032. This note had a coupon rate of 6.75% and a maturity date of March 15, 2032. The market price of this bond is $116.9, and a face value of $100. The yield-to-maturity is 5.53%.
The second bond that Sheppard considered representative of the company’s outstanding borrowings was a note due in 2012. This note had a coupon rate of 6.625%, and a maturity date of October 15, 2012. The market price of this bond is $107.5, and a face value of $100. The yield-to-maturity is 1.56%.
To determine the yields for the two representative outstanding Heinz debt issues as of the end of April 2009, the same calculations were done using 2009 numbers instead. The first bond that Sheppard considered representative of the company’s outstanding borrowings was a note due in 2032. This note had a coupon rate of 6.75% and a maturity...