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UVA-F-0982
Mead Corporation: Cost Of Capital
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This case was prepared by Kenneth Eades for the purposes of classroom discussion. Some figures have been changed at
the request of the company. Copyright 1991 by the University of Virginia Darden School Foundation, Charlottesville,
VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication
may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means
electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School
Foundation. Rev. 5/95.




MEAD CORPORATION: COST OF CAPITAL


On February 14, 1991, Cheryl Harris, business analyst at Mead Corporation, had just begun
the process of estimating Meads cost of capital for the fourth quarter of 1990. Like most other
major corporations, Mead used its weighted-average cost of capital (WACC) to evaluate new
investment proposals as well as to measure corporate and divisional performance. Mead was
unique, however, in its practice of updating the hurdle rate every quarter and analyzing the factors
responsible for its change. Looking back at the companys history of WACC estimates, Ms. Harris
observed that Meads cost of equity had been increasing relative to its cost of debt over the past few
years. Hence, as part of her analysis, she hoped to explain why the cost of equity had increased and
recommend whether the company should consider the increase a problem. Her more immediate
concern, however, was the presentation she was to give the next morning to William Enouen,
Meads chief financial officer, who had asked to see Ms. Harriss WACC estimate.


Mead Corporation

Mead Corporation was founded in 1846 by Daniel E. Mead and incorporated in 1930. In the
ensuing years, Mead, Inc., grew to become a leading producer of paper and forest products.
Included in the companys product line of forest derivatives were printing paper, writing paper,
specialty paper, lumber, wood pulp, corrugated containers, and packaging products. The company
also owned and operated a national distribution network for paper packaging and supplies. For
beverage packages and packaging systems as well as for paper-based school and office supplies,
Mead was the leading manufacturer in the United States.

In addition to its forest and paper-based products, Mead had been involved in electronic
publishing and the development of color imaging. Mead Data Central (MDC), a wholly owned
subsidiary of Mead, Inc., owned several publishing companies--for example, The Michie Company
in Charlottesville, Virginia, which published and distributed the legal statutes of 23 states. MDC
also marketed the LEXIS and NEXIS information services. LEXIS was a computer-based data-
retrieval system designed for legal research that had been expanded to include financial information
from leading investment banks, brokerage firms, and research companies. NEXIS was an on-line
UVA-F-0982

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general-information-retrieval service frequently available in libraries and news departments of the
print and broadcast media.

After having invested approximately $200 million over five years in the development of its
color-imaging process called Cycolor, Mead had announced in December 1990 that the demand
for color copying was growing too slowly to justify remaining in the business. The writeoffs
associated with the discontinuance had resulted in Meads fourth-quarter earnings per share falling
from the third-quarter figure of $0.63 to $0.17. The company projected that the writeoffs would be
completed before the second quarter of 1991, at which time profits were expected to return to
normal. The announcement regarding discontinuation of its color-imaging business did not appear
to have adversely affected Meads common stock price, which had risen to $25.75 on December 31,
1990, from $24.25 on October 1, 1990.


Meads Cost of Capital

Mead had conducted an internal study in 1984 of the companys cost-of-capital calculation
method. Subsequently, top management implemented a strategy to estimate the cost of capital each
quarter and decompose it into its components for comparison with historical estimates. The cost of
capital had become an important benchmark for measuring both corporate and divisional
performance. Although several other factors were used in the evaluation of Meads divisions,
earning a return on investment greater than the cost of capital was considered the single most
important performance measure. One of the recommendations of the study was that the MDC
division, because of its higher risk, should be held to a higher required rate of return standard than
the rest of the companys divisions. Thus, while the other divisions were evaluated against the
companys WACC, MDCs performance was compared with Meads WACC plus an additional 4
percent.
1
The same 4 percent risk premium had been used for MDCs cost of capital since 1984.

In addition to measuring internal performance, the cost of capital also served as a barometer
of the external markets perception of the company. For example, the cost of equity reflected the
markets assessment of the companys risk. If senior managements assessment of Meads risk was
substantially less than the markets, the company could take advantage of the markets pricing by
executing a share-repurchase program. Following the stock market crash in 1987, Mead repurchased
approximately 282,000 shares on the open market. In 1990, the company repurchased 5.0 million
shares at an average price of $26.69, which approximated the companys 1990 book value of $26.28
per share.

Studying the components of the WACC allowed management to discriminate between
changes in capital costs caused by macroeconomic variables such as interest rates and changes
caused by firm-specific variables such as the companys beta or its capital structure. Changes in
firm-specific variables were considered to be somewhat under managements control, whereas a


1
Casewriters estimate.