The Cost of Capital for Spectrum Corporation (answer the following 6 questions including a,b,c,d,e)
You have recently been hired by Spectrum Corporation in its treasury management department. Spectrum was founded ten years ago by Tom Sawyer and produces electrical equipment. The company is privately owned by Tom Sawyer and his family, and it had sales of $282.6 million last year.
Spectrum primarily sells its products directly to its business customers throughout the country. Spectrum’s growth to date has come from its quality and price competitiveness. When the company had sufficient capital, it would expand production. Relatively little formal analysis has been used in its capital budgeting process. Tom has just read about capital budgeting techniques and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Tom would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. Tom wants you to use a similar company to estimate the cost of capital (WACC) for Spectrum, and he has chosen Eaton Corporation (ticker: ETN), which has the product line somewhat similar to that of Spectrum, as a representative company. The following questions will lead you through the steps to calculate this estimate.
1. Most publicly traded corporations are required to submit 10Q (quarterly) and 10K (annual) reports to the SEC detailing their financial operations over the previous quarter or year, respectively. These corporate filings are available on the SEC website at https://www.sec.gov/edgar/searchedgar/companysearch.html. Go to the SEC website and enter “ETN” in the “Search for Company Filings” link and search for SEC filings made by Eaton Corporation. Find the most recent quarterly report (10-Q) or annual report (10-K) and download the form. Look on the balance sheet to find the book value of debt and the book value of equity. Look further down the report and find Eaton Corporation’s long-term debt.
2. To estimate the cost of equity for Eaton Corporation, go to finance.yahoo.com and enter the ticker symbol “ETN”. Follow the various links at this website to find answers to the following questions:
a) What is the most recent stock price (and provide the associated date) listed for Eaton Corporation?
b) What is the market value of equity, i.e., market capitalization?
c) How many shares of stock does Eaton Corporation have outstanding?
d) What is the beta for Eaton Corporation?
e) Now go back to finance.yahoo.com and follow the “MarketsUS Treasury Bond Rates”
link from the horizontal menu. What is the yield on three-month Treasury bills? (Note that the Treasury bond yield is quoted as the “last price” and in percentage. For example, if the “last price” is 0.15, it means that the bond yield is 0.15% or 0.0015). Using a 7 percent market risk premium (i.e., RM – rf = 7% or 0.07), what is the cost of equity for Eaton Corporation using the CAPM?
3. Find the list of competitors of Eaton Corporation in the same industry. You can try online sources, such as hoovers.com, for this purpose. Select only U.S.-based competing companies for this task. Suppose after the search, you identify three competitors: Emerson Electric Company (ticker: EMR), AMETEK, Inc. (ticker: AME), and Rockwell Automation, Inc. (ticker: ROK).
a) Find the beta for each of these three competitors, and then calculate the industry average beta.
b) Using the industry average beta, what is the cost of equity?
c) Does it matter if you use the beta for Eaton Corporation or the beta for the industry in this case?
4. You now need to calculate the cost of debt for Eaton Corporation. Go to http://finra- markets.morningstar.com/BondCenter/Default.jsp. Under Market Data Center Bonds Guide, choose “search” then enter “ETN” as the Symbol/CUSIP, and find the yield to maturity for each of Eaton Corporation’s non-callable bonds (you should use bonds with the issuer name “EATON CORP”). Click on each bond to find its date of issuance, total value, and other details.
a) What are the weighted average costs of debt for Eaton Corporation using the book value weights of the bonds? What are the weighted average costs of debt for Eaton Corporation using the market value weights of the bonds? (Note that for the questions in part 4a, use only the values of the bonds reported on FINRA website to calculate the book value and market value weight of each bond. If the value of a bond is not reported on this website, simply ignore that specific bond).
b) Does it make a difference in this case if you use book value weights or market value weights of the bonds?
5. You now have all the necessary information to calculate the weighted average cost of capital (WACC) for Eaton Corporation.
a) Calculate the weighted average cost of capital for Eaton Corporation using the book value of equity and book value of debt weights, assuming Eaton Corporation has a 25 percent marginal tax rate. Then redo the calculation using the weights based on market value of equity and book value of debt. For this question, use the long-term debt value reported in the balance sheet of the company to calculate the book value of debt weight relative to equity weight.
b) Which cost of capital number in part (5a) is more relevant?
6. You used Eaton Corporation as a representative company to estimate the cost of capital for Spectrum.
1. a) What are some of the potential problems with this approach in this situation?
2. b) What improvements might you suggest?
