Capital Structure and Cost of Capital Relative to Peers

Jackie Zhao is an analyst at Momentum Capital. She has been tasked with evaluating Marigold’s WACC, a company the management is looking to acquire. Marigold operates in the agriculture sector, manufacturing farm equipment such as tractors and combined harvesters. She gathers information about Marigold and publicly traded agricultural equipment manufacturers presented in Exhibit 1.

$$ \textbf{Exhibit 1: Information on Marigold and Peer Companies} \\ \begin{array}{l|c|c} & \textbf{Marigold} & {\textbf{Agricultural Equipment} \\ \textbf{Manufacturers’ Average} } \\ \hline { \textbf{Commons Size} \\ \textbf{Balance sheet} } & & \\ \hline \text{Accounts receivables} & 9\% & 10\% \\ \hline \text{Inventory} & 5\% & 4\% \\ \hline \text{Cash and cash equivalents} & 12\% & 14\% \\ \hline \text{Other current assets} & 6\% & 5\% \\ \\ \text{PPE (net)} & 24\% & 26\% \\ \hline {\text{Goodwill and} \\ \text{intangible assets}} & 20\% & 29\% \\ \hline \text{Other assets} & 4\% & 4\% \\ \\ \textbf{Other Information} & & \\ \hline \text{Debt (millions)} & 20.4 & 312 \\ \hline \text{Assets (millions)} & 100 & 1376 \\ \hline \text{EBITDA (millions)} & 9.6 & 104 \\ \hline \text{Marginal tax rate} & 20\% & 22\% \\ \hline \text{Interest expense (millions)} & 1.3 & 24 \\ \hline \text{Beta} & N/A & 1.36 \end{array} $$

Notes:

• 40% of the company’s revenue comes from spare part sales, and 6 customers in the same geographic location contribute 60% of revenues.
• The company is family-owned, with the founder heavily involved in its operations.

Zhao relies on an internally developed synthetic bond yield schedule to estimate the company’s cost of debt.

$$ \textbf{Exhibit 2: Synthetic Credit Rating Schedule} \\ \begin{array}{c|c|c|c} \textbf{Credit Rating} & \textbf{Credit Spread} & \textbf{IC} & \textbf{D/E} \\ \hline AAA & 0.7\% & IC > 10\text{times} & D/E < 15\% \\ \hline AA & 1.2\% & 9 < IC < 10 & 15\% < D/E < 20\% \\ \hline A & 1.5\% & 7 < IC < 9 & 20\% < D/E < 25\% \\ \hline BBB & 2.2\% & 5 < IC < 7 & 25\% < D/E < 30\% \\ \hline BB & 3\% & 4 < IC < 1.6 & 30\% < D/E < 40\% \end{array} $$

The YTM on a 10-year benchmark government bond for emerging market countries is 6%. Zhao estimates Marigold’s cost of debt by estimating a synthetic bond yield on the company’s 10-year non-traded bonds. Further, she uses the build-up approach and CAPM to estimate Marigold’s equity cost. Finally, Zhao assigns the following risk premiums

• Size premium (SP): 7%.
• Equity risk premium (ERP): 5%.
• Industry premium (IP): 1%.
• Specific-company risk premium (SCRP): 6%.
• Country risk premium (CRP): 2%.

To estimate Marigold’s WACC, Zhao assumes Marigold’s current capital structure is its target capital structure.

Question

From the case above, Marigold’s cost of equity, using the expanded CAPM, is closest to:

1. 27%.
2. 24%.
3. 6%.

Solution

The correct answer is A.

$$ \begin{align*} r_e &=r_f+\beta_{\text{peer}}\left(ERP\right)+SP+IP+SCRP \\ r_e & =6\%+1.36\left(5\%\right)+7\%+1\%+6\% \\ r_e &= 26.8\% \approx 27\% \end{align*} $$

B is incorrect. It uses the build-up approach.

$$ \begin{align*} r_e & =r_f+ERP+SP+SCRP \\ r_e & =6\%+5\%+7\%+6\% \\ r_e & =24\% \end{align*} $$

C is incorrect. This is the risk-free rate.

Reading 20: Cost of Capital: Advanced Topics

LOS 20 (f) Evaluate a company’s capital structure and cost of capital relative to peers.