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Global Cost of Capital - ITS


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3/2/2016
International Technology Systems (ITS) is a hypothetical multinational company in the IT industry. The company is a major
player in the industry catering to clients from a variety of industries. ITS has different segments specializing in major areas of its
operation. The case provides an opportunity to examine various issues that need consideration while making capital budgeting
decisions. One of the significant issues is that of determining the cost of capital on the basis of which the hurdle rate is calculated
in deciding whether a project is worth accepting. This forms the central issue around which the case is structured. This case is
suitable for use in a core Finance courses of MBA programs. Gordon Crown, Chief Financial Officer of ITS, would like you to
help him develop a companywide cost of capital policy that is consistent with modern finance theoretical constructs. He would
also like you to provide your recommendation on the acceptability of the projects. He also feels that since stock prices often
fluctuate, it would be advisable to use book value weights in computing the component capital costs and the cost of capital.
However, his young deputy, Helen Chang who is a recent MBA graduate, feels that market prices are very important indicators
of the health of the company and they provide very good signals to the corporation in terms of the future directions. As such, she
feels that the market value weights approach would be the best approach. She is also of the opinion that the Required Rate of
Return on any given project, in addition to the WACC, should also include various risk premiums like stand-alone or project
specific risk which can be further broken down into political risk, repatriation risk, exchange rate risk etc. Further, she believes
that the required rate of return should be increased by about 1% to allow for capital investment projects that have no cash
inflows, such as pollution control equipment and safety equipment.

After a quick glance at the available information and the decision making requirements of the
Gordon Crown, you have decided that at the minimum you have to do the following:
Question 1: For component costs:
A. Compute the before- and after-tax costs of ITS debt.
B. Compute the cost of equity (assuming all funds come from internal sources):
i. Using the constant growth Gordon Dividend Valuation Model
ii. Using the Security Market Line Equation (SML) from the CAPM
Question 2: Compute the Weighted Average Cost of Capital (WACC) based on cost of equity
estimated under the Gordon's Constant Growth Dividend Valuation Model:
A. Using book value weights for debt and equity
B. Using market value weights for debt and equity
Question 3: Compute the WACC based on cost of equity estimated under the CAPM:
A. Using book value weights for debt and equity
B. Using market value weights for debt and equity
Question 4: Address the pros and cons of using market value weights versus book value
weights and reconcile the divergent views of Crown and Chang.
Question 5: Compute the Required Rate of Return for the project(s), adding appropriate risk
premiums subjectively to the WACC's in questions 2 and 3. These risk premiums can differ
depending on the nature and continental location of the projects.
Question 6: Make a recommendation as to which, if any, of the investments identified in Table 6
should be accepted taking into account the capital constraint.
Contents
Pre-tax and After-tax cost of debt ................................................................................................... 3
Cost of Equity ................................................................................................................................. 3
Constant Growth Gordon Dividend Valuation Model ................................................................ 3
CAPM Model .............................................................................................................................. 4
Computation of WACC .................................................................................................................. 5
Based on Book Value .................................................................................................................. 5
Based on Market Value ............................................................................................................... 5
Pros and Cons of using market value weights vs. book value weights........................................... 6
Required Rate of Return for eight project under consideration by ITS in N+6 .............................. 8
Recommendations ........................................................................................................................... 8

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Pre-tax and After-tax cost of debt
ITS bonds are rated as Aaa by Moody and AAA by S&P which are regarded as the
highest investment grade. As on March 1, 2016, as per noting on
http://www.federalreserve.gov/releases/h15/Update/, the YTM of Aaa coporate bond is
3.84%.

Even though the case indicates the weighted average cost of debt as 4.87% based on
existing book size and respective coupon rates, yet this cannot be considered as the cost of debt
of ITS. Coupon rate are the rate of interest which are decided at the time of issuance of bonds
which is not the best estimate of the rate of interest at which the bonds can be currently issued.
Issuance of new debt will be based on current market environment and existing financial position
of ITS. This to a great extent is represented by YTM which is yield-to-maturity. YTM is the rate
of return an investor would earn if he invests in the bond at todays price and hold it till maturity.

ITS bonds are Aaa rated by Moody and since an average Aaa Moodys rated corporate
bond has the YTM of 3.84%1, ITS before-tax cost of debt is 3.84%.

Thus,

Before-tax cost of debt 3.84%

After-tax cost of debt 3.84% * (1 28.10%) = 2.76%

Cost of Equity

Constant Growth Gordon Dividend Valuation Model


As per Gordon Model, Cost of equity is given as:

Current Dividend Per Share * (1 + Constant Growth) / Current Price + Constant Growth

Growth has been calculated based on two different methods and the average of both
methods have been taken as final constant growth. First method calculates growth based on
sustainable growth formula which is Retention ratio * RoE. Second method calculates growth
rate based on last three years compounded annual growth rate. First method shows the growth
rate at 24.09% and second method shows the growth rate as 28.92%.

1
http://www.federalreserve.gov/releases/h15/Update/

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Period N N+1 N+2 N+3
Normalized Net Income 7497 7994 9386 10405
Dividend Payout 1174 1250 1683 2147
Net Worth 31688 33098 28506 28469
Payout Ratio 15.66% 15.64% 17.93% 20.63%
Retention Ratio 84.34% 84.36% 82.07% 79.37%
RoE 23.66% 24.15% 32.93% 36.55%
Sustainable Growth 19.95% 20.38% 27.02% 29.01%
Average Growth Rate 24.09%

Dividend Per Share 0.70 0.78 1.10 1.50


Growth 11% 41% 36%
Average Growth Rate 28.92%

Overall Average 26.51%

Overall average constant growth rate is 26.51%. Current market price is given as $95 per
share. Current year dividend per share is $1.50.

Cost of equity $1.50 * (1+26.51%) / 95 + 26.51% 28.51%

CAPM Model
As per CAPM Model Cost of Equity is given as:

Risk-Free Rate + Stock Beta * (Average Market Return Risk-Free Rate)

Or, Risk-Free Rate + Stock Beta * Equity Premium

Stock Beta 0.91; Equity Premium 5%; Risk-Free Rate represented by U.S 10 year Treasury
Bonds2 1.83%

Hence, Cost of Equity 1.83% + .91 * 5% = 6.38%


Note: Although the case asked to compute cost of equity under both model, but the cost derived using Gordon constant growth
model is the right indicator. This is because, three years is too small a period for calculating average annual growth rate and
any distortions may skew the number. Based on this average annual has come around 26.51% which cannot sustainable forever
and hence cost of equity derived using this method may not be the best estimate.

2
74.143.218.180/qa/expert/browse_questions.php

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Computation of WACC

Based on Book Value


Period N+3
Overall Long-Term Debt 26,729
Less: Current Portion of Debt (3,690)
Less: SFAS No. 133 Fair Value incl above (432)
Add: Net unamortized discount incl above 65
Actual Long-term Debt 22,672
Total Equity 28,469
Total Capital Employed 51,141

Weight of Debt 44.3%


Weight of Equity 55.7%

Note: For the purpose of WACC, only long term debt is relevant. Current portion of long term debt has been
ignored while calculating weight of debt in total capital employed. This will be out of the total debt of $12,295
million which has maturity from N+4 to N+7. Also long-term derivative instruments and unamortized discount has
been ignored.

WACC Weight of Debt * After-tax cost of Debt + Weight of Equity * Cost of Equity

Under Gordon Model Under CAPM


After-Tax Cost of Debt 2.76% 2.76%
Cost of Equity 28.51% 6.38%
Weight of Debt 44.30% 44.30%
Weight of Equity 55.70% 55.70%

WACC 17.10% 4.78%

Based on Market Value


Computation of Market Value of Debt
Nature Coupon Maturities Balance as Annual Interest Average Maturities from N+3 Ratings YTM Market
Interest Rate on N+3 Expense (Semiannual period) Value
US Debt 4.480% N+5 to N+7 $8,605 $386 6 Aaa / AAA 3.84% $7,880
US Debt 5.340% N+8 to N+9 $3,545 $189 11 Aaa / AAA 3.84% $3,177
US Debt 5.690% N+10 to N+14 $3,026 $172 20 Aaa / AAA 3.84% $2,610
US Debt 8.375% N+15 $750 $63 24 Aaa / AAA 3.84% $792
US Debt 7.000% N+21 $600 $42 36 Aaa / AAA 3.84% $561
US Debt 6.220% N+23 $469 $29 40 Aaa / AAA 3.84% $398
US Debt 6.500% N+24 $313 $20 42 Aaa / AAA 3.84% $271
US Debt 5.875% N+28 $600 $35 50 Aaa / AAA 3.84% $478
US Debt 7.000% N+41 $150 $11 76 Aaa / AAA 3.84% $144
US Debt 7.125% N+92 $850 $61 178 Aaa / AAA 3.84% $794
Euro Debt 3.40% N+4 to N+9 $2,466 $84 7 Aaa / AAA 3.84% $2,466
Yen Debt 2.20% N+6 to N+10 $767 $17 10 Aaa / AAA 3.84% $767
Swiss Francs Debt 1.50% N+4 $442 $7 2 Aaa / AAA 3.84% $442
Other foreign current Debt 2.70% N+4 to N+9 $89 $2 7 Aaa / AAA 3.84% $89
Total $22,672 $1,118 $20,868

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For the purpose of market value of debt, current portion of long term debt has been removed.
This is clear that the current portion of long-term debt of $3,690 million belongs to group which
has coupon interest rate of 4.48%. Hence the balance $8,605 million will have maturity from
N+5 to N+7. It is assumed that coupons on each of the long-term bond are paid semi-annually.
For the purpose of maturity, semi-annual period has been counted starting six months from end
of N+3 and average maturity period taken as mid value of the given range. Market value of Debt
is computed using excel formula (-)PV(YTM, Semi Annual Periods, Semi Annual Coupon,
Maturity Value

Market value of equity Total common stock outstanding * Current trading price of stock

Or, Market Value of Equity 1,385.23 million shares * $95 = $131,596.85 million

Weights as per market value,

Market Value of Debt $20,868


Market Value of Equity $131,597
Total Capital Employed $152,465

Weight of Debt 13.7%


Weight of Equity 86.3%

WACC as per market value,

Under Gordon Model Under CAPM


After-Tax Cost of Debt 2.76% 2.76%
Cost of Equity 28.51% 6.38%
Weight of Debt 13.69% 13.69%
Weight of Equity 86.31% 86.31%

WACC 24.99% 5.88%

Pros and Cons of using market value weights vs. book value weights

Market Value as weights

Pros This shows the most appropriate weights as an investor would require market
determined rate of return (WACC) over market value of capital and not historic book value of
capital. In addition, market value represents the fair estimate of health of the company based on
expected future performance keeping in mind as on date market and company specific factors
affecting future earnings. The component costs of capital are opportunity costs and are
determined by the capital markets and hence the weights should also be taken as market value.

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Market values as weights are superior as they reflect the economic values and are not influenced
by the accounting policies.

Cons It is not always simple to calculate the market values of all the components of capital
being in use by the firm. Market value fluctuates widely and frequently and market value based
target capital structure of the firm needs to be adjusted on a real-time basis as the value of firm
changes. The estimation of market value of debt, equity or any other securities becomes difficult
if they are not listed or are not widely traded in the market and hence may involve lot of
subjectivity in the calculation.

Book Value as weights

Pros Book Values are widely preferred by the managers including ITSs CFO, Gordon Crown,
as it is easily available based on historical financial of the organization. Frequent fluctuation in
securities prices in the market makes it easier for the managers to use book value as weights
while determining target capital structure of the firm.

Cons Book values are based on arbitrary accounting policies and do not reflect the true
economic value and hence many not reflect the true potential of the securities. This may result in
inappropriate weights of components of capital in the overall target capital structure. Besides,
book value ignores the future earning potential and risks which are captured in the market values.

In the given case, although there is not much of a difference between market value
($22.672 billion) and book value of debt ($20.868 billion), but we are seeing huge difference in
market value of equity ($131.465 billion) vs. book value ($28.469 billion). As a result of this
weight of equity becomes 86% in case of market value based weights vs. 56% in case of book
value based weights. This has a huge impact on WACC under both methods. Basis above
benefits, even though there are certain challenges while considering market value as weights, yet
it is the best approach while computing WACC in order to evaluate consideration of deployment
of capital for pursuing new projects as it reflects the true cost or the expectation of stake holders.

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Required Rate of Return for eight project under consideration by ITS in
N+6
Book Value Weights Market Value Weights
Project Net Investment Cost Proposed Location Est. IRR Type of Project Nature of Risk Risk premium Gordon Model CAPM Gordon Model CAPM
1 $500 Europe 26.30% Existing product, new market Moderate High 1.00% 25.99% 6.88% 18.10% 5.78%
2 $400 USA 13.50% New product, new market High 1.50% 26.49% 7.38% 18.60% 6.28%
3 $650 Asia 8.60% Expand existing product in existing market Moderate 0.50% 25.49% 6.38% 17.60% 5.28%
4 $1,500 Asia 23.40% New product, existing market Moderate High 1.00% 25.99% 6.88% 18.10% 5.78%
5 $350 USA 24.60% Replace Equipment Minimum 0.00% 24.99% 5.88% 17.10% 4.78%
6 $750 Europe 10.20% Expand existing product in existing market Moderate 0.50% 25.49% 6.38% 17.60% 5.28%
7 $250 Asia 26.70% Existing product, new market Moderate High 1.00% 25.99% 6.88% 18.10% 5.78%
8 $325 Asia 18.80% New product, existing market Moderate High 1.00% 25.99% 6.88% 18.10% 5.78%

Note: Based on table 6 given in the case, nature of risk is mapped to all eight projects under
consideration. On the basis of nature of risk and type of project, different risk premiums are
assigned.

For minimum risk 0.00%; For moderate risk 0.50%; For moderate-high risk 1.00%; For
high risk 1.50%

Considering above risk premium project specific WACC are derived under both book value and
market value weightage system.

Recommendations
Given the thesis above and considering market value based weights superior over book value
weights, following recommendations are made.
Market Value Market Value Excess return over
Project Net Investment Cost Proposed Location Est. IRR Type of Project Nature of Risk Risk premium Gordon Model CAPM WACC Verdict Ranking
1 $500 Europe 26.30% Existing product, new market Moderate High 1.00% 18.10% 5.78% 8.20% 20.52% Accept 2
2 $400 USA 13.50% New product, new market High 1.50% 18.60% 6.28% -5.10% 7.22% Reject
3 $650 Asia 8.60% Expand existing product in existing market Moderate 0.50% 17.60% 5.28% -9.00% 3.32% Reject
4 $1,500 Asia 23.40% New product, existing market Moderate High 1.00% 18.10% 5.78% 5.30% 17.62% Accept 4
5 $350 USA 24.60% Replace Equipment Minimum 0.00% 17.10% 4.78% 7.50% 19.82% Accept 3
6 $750 Europe 10.20% Expand existing product in existing market Moderate 0.50% 17.60% 5.28% -7.40% 4.92% Reject
7 $250 Asia 26.70% Existing product, new market Moderate High 1.00% 18.10% 5.78% 8.60% 20.92% Accept 1
8 $325 Asia 18.80% New product, existing market Moderate High 1.00% 18.10% 5.78% 0.70% 13.02% Accept 5

Project 1, 4, 5, 7 and 8 should be accepted as they deliver IRR higher than WACC and hence are
profitable under both the methods. Remaining three projects (2, 3 and 6) has the potential to
generate negative under Gordon Model. Based on this selection, the ranking has been assigned
with project generating maximum excess return over WACC as first choice of investment.
Hence, based on above selection of give projects, $2.925 billion can be invested of the total
available capital of $4.2 billion.

Note: As stated earlier in the case, CAPM is superior to the Gordon model and if decision is to be made based on
CAPM, then all projects are profitable as all are generating IRR higher than the WACC. Based on excess return,
except project 3, all other seven projects should be accepted. Inclusion of project 3 would take the total investment
($4.725 billion) beyond available capital of $4.2 billion. Selection of all seven projects would be similar in sequence
of highest to lowest excess return over WACC (Project 7, 1, 5, 4, 8 and 2 respectively).

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