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H. J. Heinz Estimating Cost of Capital in uncertain times Case Solution

Weighted average cost of capital (WACC) is theminimum rate of return that investors require from the investment. However, the function of the WACC is to determine the minimum rate of return at which investors are ready to invest in aparticular company or a particular project. Indeed, the determination of the WACC has two important section. First is the valueand cost of debt. Second is the value and cost of equity.Meanwhile, if we see the further breakdown in Figure 1,it demonstrates how to approach the WACC.

Furthermore, the WACC represents the investors’ concern because, if there is high risk in the market, investors would also require high returns for the risk they would take by investing in the company or a project. Consequently, if there is low risk in the market, then theinvestor would also expecta low return from the investment. However, the situation in the market is very complex since there has been arecession. If we take a look at the food industry, we can determine that the industry has a low volatile relation with the market.

Because peoples would not stop eating even if there is arecession because the company is not selling washing machines or cars that would have adverse consequences due to declining economy. There would be some negative impacts on the company,for instanceon the WACC, economy, and investors. It is highly anticipated that WACC would also be affected by the changes that have taken place in recent times.Therefore to approach the proper WACC, thecompany should take given historic yields for the short term debt[i] and long term debt[ii].

Furthermore, the company should take ten years yield as risk-free rate, assuming the government security rate. On the other hand, there is uncertainty in themarket, thus investors are likely to expect ahigh return on the investment. The recent premium was 6%, so the company should choose7.5% as thepremiumwhich has been calculated over a long period to approach thefair cost of capital. Similarly, the company should also select the beta 0.62 that has also been calculatedover along period. Therefore, the WACC for 2010 after various calculations and assumption is 7.14%. See Exhibit 1

WACC is sensitive from the investment’s perspective.The WACC helps in determining if the investment is worthwhile for the company to undertake the project.In. case the company were to approach anincorrect WACC,thecompany would incur ahuge loss in future because thecompany would not be able to recover its invested amount.If WACC is calculated fairly with reasonable assumptions,then, it is highly anticipated that company would take theright decision in undertaking investment. Therefore, H.J Heinz should also refer to recommendations made above to approach afair WACC to meet investors’ expectations and takeright decisions in determining the investment proposals.

 Exhibit 1 Estimating Cost of Capital in Uncertain Times Year 2009 2010 Short-term Debt 61,297,000 43,853,000 Long-term Debt 5,076,186,000 4,559,152,000 Value of Equity 10,837,481,200 14,890,130,300 E/v 68% 77% D/v 32% 23% Tax 35% 35% Yields(Rd) 4.54% 4.94% Risk-Free Rate 3.16% 3.69% Premium 6.0% 7.5% Beta 0.62 0.62 Cost of Equity(Re) 6.9% 8.3% WACC 5.63% 7.14%

[i] Short-term debt refers to debt that has life within the year, therefore company should take 1 year short-term yield of 2009, and 2010 to calculate fair cost of capital.

[ii] Long term Debt refers to the debt that has life more 10 years. So, company should take cost of debt that is applied on the debt that has life more than 10 years. Thus, company should take 30 years yield given in Exhibit 3

wacc

[1] Short-term debt refers to debt that has life within the year, therefore company should take 1 year short-term yield of 2009, and 2010 to calculate fair cost of capital.

[1] Long term Debt refers to the debt that has life more 10 years. So, company should take cost of debt that is applied on the debt that has life more than 10 years. Thus, company should take 30 years yield given in Exhibit 3...................................

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