P&g Case Study - Cost of Capital Analysis

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However, using Mr. Ron Emory’s method to find the answer does not yield the appropriate solution. Based on his method of calculation, the bonds have a total return of 9.09%. However, using this figure to discount all the future cash flows to the present, the solution does not arrive at the current discounted bond price of $92.5. This suggests that Mr. Ron Emory’s method is not appropriate to reflect the yield of the bond since the return wouldn’t reflect the current market value of the bond.

On the other hand, besides the concern of approximation problem when using Mr. Ron Emory’s method, Mr. Ron Emory’s approach is also primarily based on the perspective of a bondholder. However, as the bond is closer to maturity, the price will eventually converge to the par value. In this case, even if P&G’s credit profile did not change, Mr. Ron Emory’s approach would realize a lower cost of debt. However, considering that P&G’s credit profile did not change, its cost of debt should remain constant over the horizon of time. Therefore it can be argued that Mr. Ron Emory’s approach does not work in finding the true cost of debt for the overall company.

On the contrary, using the yield-to-maturity approach, would realize more self-consistent pricing, reflecting the true cost of debt of P&G. Yield-to-maturity (YTM) not only accounts for coupon payments and gains and losses, but it also accounts for reinvestment of the coupons up until bond maturity. Thus, it is a more accurate reflection of the “true return” of a bond. Additionally, if instead, a discount rate equivalent to the stated YTM of 9.18% were used instead of 9.09%, the current market value of the bond would equate to $92.5, suggesting YTM is what is currently being used by the market to value the bond.

3. The simple ownership of a share does not explicitly bear interest income. Nevertheless, for companies the cost of equity is an important element as it constitutes the expected return that investors require for holding the stock of a company, and thus, is equivalent to the cost for a company to maintain a share price that appropriately rewards investors. The Capital Asset Pricing Model (CAPM) is one of the most frequently used measures for describing the relationship between risk and expected return.

[pic 2]

Where:

• = the required rate of return on equity or the cost of equity[pic 3]

• = the risk free rate [pic 4]

• = the market risk premium [pic 5]

• β = beta coefficient = unsystematic risk

In short, the model estimates the market rewards for a risk free investment, and shows how much investors demand for the additional risk they take on in an investment.

The model’s comprehensive approach in finding the required return on equity may be a bit daunting and demanding. Estimating the market equity risk is challenging as it requires the calculation of average capital gains as well as average dividend yields over a longer time period in order to produce a significant result. Consequently, in some circumstances other models of more portable nature may be more attractive.

Dividend growth model

The dividend growth model uses predicted future dividends and then discounts them back to present value. The model is used to estimate the future share price through prediction of dividends. This information, in conjunction with the predicted growth rate of dividends, can therefore be used as a proxy for how much return shareholders expect from their investments. Therefore, the expected return to investors is the cost of equity to the company. Shown below is a breakdown of the dividend growth model, although more details can be found in Appendix B.

For P&G,

Using dividend growth model to find cost of equity:

[pic 6]

Therefore,

[pic 7]

For Clorox,

Using dividend growth model to find cost of equity:

[pic 8]

Earnings capitalization model

The earnings capitalization model looks at the rate of return investors expect from an investment, a company’s cost of equity. The model’s required inputs are relatively straightforward to access and they are easy and intuitive to understand, thus making the model attractive as it can be easily utilized to estimate the expected return of an investment over a given period.

For P&G,

Using earnings capitalization model to find cost of equity:

[pic 9]

Therefore,

[pic 10]

For Clorox,

Using earnings capitalization model to find cost of equity:

[pic 11]

As shown in the calculations of both the dividend growth and earnings capitalization models, Clorox has a higher cost of equity, even without using the CAPM model, which makes intuitive sense since it is a smaller and less diversified business than P&G, thereby making it a naturally riskier investment. Although the riskiness of debt isn’t directly factored into these models, indirectly the firms’ capital structures may impact the earnings and dividends per share as well as the stock prices so the fact that Clorox utilizes much less debt than equity compared to P&G may also impact these models, though to an indeterminable extent at this point.

To clarify, the above 4 calculations utilize the next 5 years’ annualized dividend growth rates or earnings growth rates as the perpetual growth rates. However, in reality, this is seldom the case because a company’s growth will slow down after a period of rapid expansion. After a business matures and industrial competition intensifies, its growth will eventually be lower than the required return. Although having a perpetuity growth rate greater than the speed of GDP growth is infeasible for perpetuity, as a mode of comparison between two firms both with the same high growth rates, it can still be counted as a useful tool if more smooth long-term figures

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