H. J. HEINZ: Estimating The Cost Of Capital In Uncertain Times

Heinz is an established processed food manufacturing giant, with $10 billion in revenues and 29,600 employees around the globe. Heinz operates in over 200 countries. The company is organized into business segments based on regions: North American consumer products, Europe Foodservice, Asia Pacific and the rest of the world. Around 60% of the company revenues were from outside United States and the company is increasingly focusing on emerging markets, which have generated 30% of recent growth and 15% of total sales. With continued uncertainty following the recession in late 2007, Heinz has seen volatility in stocks and finding it difficult to maintain growth in sales. Because of uncertainty in the market, company wanted to recalculate its weighted average cost of capital, which would reflect the current conditions of economy and help the company make right capital budgeting decisions on its future projects and investment opportunities. Heinz’s Cost of Debt:

Recent markets had seen unusually low borrowing costs due to turmoil in financial market. Heinz has two outstanding bonds and we calculated the cost of borrowing by using YTM (Yield to Maturity) at 5.37%. See Exhibit 1 for Cost of Debt. Heinz’s competitors also have a reasonably similar borrowing costs and variability seen by financial conditions in near term does not show significant change in borrowing costs. ( ?? Need to check this ???) Heinz’s Cost of Equity: See Exhibit 2 for details of Cost of Equity We calculated cost of equity capital by using the SML. Regression of the capital equity risk was performed and the various market beta’s were used based on ? Rs = Rf + Beta x [ Rm – Rf ]

Highest return noted was 7.29% ( = 3.69% + 0.72 * 5.3% ).
Because of the market risks, different values of Market risk premiums and Beta was considered (using regression).

Heinz’s WACC Calculation for a range with focus on Beta variation: We computed the portions of debt and equity from the market values of debt and equity. See Exhibit 3 WACC was calculated was between 5.40% and 6.48% using a variation of Beta. See Exhibit 4.

Heinz’s Competitor: See Exhibit 5
WACC calculation: Heinz’s competitors are Kraft (larger more diversified) to Campbell Soup and Del Monte relatively smaller in size. WACC considerations featured outstanding debt (cost of debt ?) and equity. WACC range we found was 5.10 – 5.76%, with Campbell having 1.98 (because of very low debt – partly the smaller growing business, going towards more equity.

1.) Cost of Capital in the given case is estimated based on some assumptions and considerations. Once assumption was market risk premium. We took different values (ranges from 0.05 to 0.09) to calculate cost of capital. 2.) There is an obvious link between the increase in market risk and decrease in equity values. The CAPM defines the cost of equity as a risk-free rate plus a premium for risk, where risk is a market risk premium multiplied by beta. Since beta is a relative measure of risk, the impact on the overall market return is unlikely to be reflected in changes in beta. The overall adjustment must be reflected in the market risk premium.

Global economic events have resulted in a clear increase in market risks along with a decrease in equity values, resulting in an increase in the market risk premium. 3.) Lower risk free rates, holding all else constant, result in lower discount rates, and lower discount rates, all else held the same, will result in higher value. Lower risk free rates are good for the economy and markets. Since government bond rates are used as risk free rates to estimate discount rates in valuation or hurdle rates in corporate finance, there has been a great deal of hand wringing and angst among valuation practitioners on the consequences. In fact, if you allow for the increase in sovereign risk across the globe, you could argue that the “true” risk free rates are even lower than the already low government bond rates.