Background Concepts:

1. CAPM:
The Capital Asset Pricing Model (CAPM) is a valuation technique used for valuing equity
investments. It takes into account the market risk in the form of a parameter called Beta (β).
Beta measures the risk associated with the given investment. The expected return for such a
security can be calculated by adding a risk spread to the prevailing risk-free interest rates.
This risk spread is arrived at by multiplying the expected risk premium to be paid by the Beta
measure.

2. Cost of Capital:
Cost of capital is an important concept required for any company. Basically, it measures the
cost a company must pay for its various financing options i.e. its financing mix of debt and
equity. In case of equity, the company must pay a dividend to its shareholders and they
expect some level of appreciation in the stock price. The quantum of this expected increase
is a function of the riskiness of the company and its security. Thus, the investors expect a
premium over the risk-free rate they could have got by investing in government securities.
Thus, to keep the shareholders happy, the company must at least match the above expected
rate of return for its shareholders. This return that the company must achieve is its Cost of
Equity.
Similarly, the company must pay interest and maturity amount on its debt obligations. These
are again a measure of the prevalent market interest rates and the riskiness of the company.
As such, the lenders of the company must be guaranteed a return higher than risk-free
government securities. From this premium, we must subtract the gains the company gets
because interest payments on bonds are tax deductible. The net amount is the Cost of Debt.
These put together will give us the Cost of Capital.

3. Weighted Average Cost of Capital (WACC):

The weighted average cost of capital method is used to estimate the cost of capital from the
individual costs of debt and equity. The two costs are added together in terms of the
respective ratios of debt and equity in the firm’s capital structure.

4. Risk-free interest rates:

Government securities are generally considered risk-free in stable countries like India and
the US. As such, the returns from these securities are taken as the risk free interest rates.
Within this category, there are several types of securities. We must choose the return from
those government securities whose time period matches with the time period of our
investment. Also, long-term government security YTMs should be considered as risk-free,
rather than the yields on short term securities. Usually, we consider long-term government
Treasury Bond YTMs as the risk-free return rate.
Case Summary:
Ms. Cheryl Harris is a business analyst at Mead Corporation and she has been tasked with
estimating the cost of capital for Mead Corp. for the last quarter of the financial year 1990.

Mead Corporation is a leading producer of paper and forest products founded in 1846. Over
the years, Mead has developed a wide portfolio of paper based products and has also
diversified into other paper based activities like paper packaging, supplies and beverage
packing. Mead has also been involved in electronic publishing and development of colour
images via Mead Data Central (MDC).

In December 1990, Mead announced the termination of a $200 million program called
Cycolor. The shut-down related write-offs cause the fourth quarter EPS to fall to $0.17 from
$0.63 in the previous quarter. Profits were estimated to return to normal by the 2nd quarter
of 1991, by which time the write-offs would have been completed.

Like most other companies, Mead used a Weighted Average Cost of Capital (WACC) method
to determine company and department performance and to evaluate new investment
proposals. A 1984 survey of its WACC calculations had suggested that the MDC department
be evaluated against the company WACC plus a 4% risk premium because the MDC
department’s activities were considered more risky. It was also a practice at Mead to update
the hurdle rate at every quarter and analyse the factors responsible for its changes.

Mr. Harris’s tasks included explaining the trend of increasing cost of equity in relation to the
cost of debt over the years. She also had to account for a steadily rising Beta value of the
company. But the highest priority was to come up with the Cost of Capital estimates for the
last quarter of 1990.
Problems to be analysed:

1. Cost of Capital of 4th quarter of 1990:

The first issue Ms. Harris will encounter is to calculate the Cost of Capital for the last
quarter of 1990. She has been given a few quantities like the Beta measure, required risk
premiums and the tax rates. She has to find out the prevalent YTM for 30 year
government bonds as the risk-free returns rate. She will also have to research and find
out the Yield to Maturity for corporate bonds rated A by Moody’s in 1990 as the basis
for the required return for the corporate bonds.
These values can be used to calculate the cost of equity and cost of debt respectively.
Then, she must scrutinize the financial statements of Mead Corp. to find out the
company’s market capitalization and the total debt outstanding as on December 31,
1990. The ratio of these values will be used to assign weights to the two costs calculated
above to arrive at the total cost of capital.

2. Increasing cost of Equity:

After comparing the trend over the years, Ms. Harris observed that the cost of equity
has been rising vis-a-vis cost of debt. She has to explain the reasons for this trend and
also suggest whether this is a serious problem which the company must consider.

3. Beta increase:
She also had to analyse how and why the Beta seemed to remain at a high value and
continue to increase. She has to unearth the reason as to why the market felt that the
Mead Corp. investment was getting increasingly riskier as reflected in the increasing
trend in Beta values over the years.
 Analysis:

Mead Corporation, like most other companies, uses its WACC as a basis for performance
evaluation of the company and its departments. As such, this data is essential for people
like:

a. The company Chief Financial Officer (CFO): He would need this to estimate the
company’s financial performance and present it to his/her colleagues on the board.

b. Company Controller: The controller would require this data to compare with
projections and estimates to check the deviations from expected results.

c. CEO and top management: They would require this data to analyse the company’s
performance.

d. Department Heads: The department heads would need the Cost of Capital data to
see how their individual departments have returns have performed against this
figure.

Mead uses the CAPM model to estimate its Cost of Capital.

Cost of Equity:
Mead analysts use a service Beta value as published by Value Line Investment Survey. They
have a fixed risk premium of 6%, which in itself is a conservative estimate over the 5.5%
premium seen of the S&P 500 over the risk-free government bonds. These values are used
to calculate the Equity risk premium. This is added to the YTM on 30 years government T-
bonds as the risk-free rate. This value is the cost of equity.

Cost of Debt:
The cost of debt is obtained by taking the market YTM on long-term corporate bonds rated A
by Moody’s. We multiply this by (1-tax rate) to get the rate of return after tax. This is the
cost of debt.

Assigning Weights:
To calculate the individual weights, we need to get the market capitalization and the total
outstanding debt. These values are readily available from the 1990 balance sheet. That gives
us a equity market capitalization of USD 1531.3 million and a total debt outstanding of
1256.6 million. Using these, we get the split as 54.93% equity versus 45.07% debt. These two
values are the weights used in the WACC calculation.
 1. WACC Analysis:
Here, I have computed the Weighted Average Cost of Capital in the given table for
sake of comparison. The table is as below:

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
Equity After-
Tax
Risk Risk- Cost of Equity/ Cost Debt/ WACC
Risk Premium Free Equity Total Debt I-Tax of Debt Total (5)x(6)+
Beta Premium (1)x(2) Rate (3)+(4) Capital Rate Rate (7)x(8) Capital (9)x(10)

1981 1.1 6.00% 6.60% 12.90% 19.50% 55.00% 16.00% 52.00% 8.32% 45.00% 14.47%
1982 1.1 6.00% 6.60% 12.20% 18.80% 47.00% 15.50% 52.00% 8.06% 53.00% 13.11%
1983 1.1 6.00% 6.60% 10.80% 17.40% 59.00% 12.70% 52.00% 6.60% 41.00% 12.97%
1984 1.1 6.00% 6.60% 12.00% 18.60% 65.00% 13.50% 52.00% 7.02% 35.00% 14.55%
1985 1.1 6.00% 6.60% 9.30% 15.90% 67.00% 11.50% 52.00% 5.98% 33.00% 12.63%
1986 1.2 6.00% 7.20% 7.40% 14.60% 57.00% 9.30% 52.00% 4.84% 43.00% 10.40%
1987 1.2 6.00% 7.20% 9.00% 16.20% 62.00% 10.30% 56.00% 5.77% 38.00% 12.24%
1988 1.4 6.00% 8.40% 9.00% 17.40% 61.90% 10.20% 62.00% 6.32% 38.10% 13.18%
1989 1.4 6.00% 8.40% 8.00% 16.40% 63.70% 9.40% 62.00% 5.83% 36.30% 12.56%

03/31/90 1.4 6.00% 8.40% 8.60% 17.00% 63.10% 9.80% 62.00% 6.08% 36.90% 12.97%
06/30/90 1.4 6.00% 8.40% 8.40% 16.80% 61.20% 9.70% 62.00% 6.01% 38.80% 12.62%
09/30/90 1.4 6.00% 8.40% 9.00% 17.40% 59.50% 10.20% 62.00% 6.32% 40.50% 12.91%
12/31/90 1.4 6.00% 8.40% 8.26% 16.66% 54.93% 9.80% 62.00% 6.08% 45.07% 11.89%

The Risk Free Rate is given as 8.25% (the US Treasury Department website historical
data gives the actual value of YTM on 30 year government T-bonds in December
1990 as 8.26%, source: http://www.ustreas.gov/offices/domestic-finance/debt-
management/interest-rate/yield_historical_1990.shtml) and the Debt rate is the
equivalent YTM on long term corporate bonds rated A by Moody’s (source:
http://archives1.sifma.org/story.asp?id=86).

Beta value was taken as 1.4

Using these values, I was able to calculate the WACC as 11.89%.

The cost of capital has changed since 1985 primarily due to the following reasons:
i. Increasing value of Beta
ii. Changing YTM rates of 30 year government T-bonds
iii. Changing interest rates

Referring to appendix 1, we see that it is a replica of the above table with an extra column that
measure the ration of cost of equity to cost of debt. From that, we observe 2 locations where there
was a sharp rise in this ratio. In 1983 and 1986, the ratio rose by 0.3% each time.

This has happened primarily due to a corresponding drop in the interest rates of corporate bonds,
which made it cheaper for companies to issue them i.e. reduced cost of debt. At the same time, the
returns on equity did not drop by such a large percentage. Moreover, the Beta value continued to
increase.
Whether 4% premium is needed?
Observations and Conclusion:
1. The Cost of Capital for the 4th quarter of 1990 is 11.89%

2. The increase in cost of capital over the years since 1985 can be attributed to mainly the
changing interest rates, changing T-bond yields and changing values of Beta over the time
period.

3.