Fin 502 Managerial Finance
Andras Fekete
PNC’s Weighted Average Cost of Capital
Case 5
Due: November 6th, 2006
Prepared for Dr. James Haskins
Managerial finance
November 5, 2006
TABLE OF CONTENTS
List of Figures 3
List of Tables 4
Executive Summary 5
Introduction 6
Statement of Opportunities and Problems 7
Methodology and Analysis 8
Summary and Conclusions 24
Recommendations 25
Works Cited 27
Appendix 28
LIST OF FIGURES
Figure 1: NPC’s yield curve 10
Figure 2: Project evaluation 10
LIST OF TABLES
Table 1: Bond yield and cost of debt 9
Table 2: Sinking fund cash flow 11
Table 3: Own-bond-yiel-plus-risk-premium 12
Table 4: Cost of Equity, CAPM 14
Table 5: Cost of Equity, DCF 15
Table 6: Issuance of new common stock 18
Table 7: PNC’s WACC 18
Table 8: Capital budget 19
Table 9: Project evaluation 20
Table 10: Capital structure (weights) 21
Table 11: Capital structure (costs) 21
Table 12: Euro-denominated bonds 22
Executive Summary
The cost of capital consists of three parts: cost of debt, preferred stock, and common equity. For bond evaluation we find the yield on the bonds and deduct the taxes, for preferred stock we consider the dividends and flotation costs and for cost of equity there are three different ways to estimate that is described in this report. For PNC the best is to use CAPM, because it considers market risk and that makes more informative to investors. To obtain the cost of weighted average cost of capital we multiply the cost of the above components with the desired weight. The heavier the weight is in certain component the bigger part it finances of the capital budget, and the closer the cost of capital to the cost of the particular component.
The estimated retained earnings will be $2.4 million, which can finance $2.9 million capital budget. To take advantage of the possible projects PNC will need $21 million in capital budget. To reach this amount by keeping the capital structure PNC should sell $15 million in common stock.
The change in the capital structure will change the cost of capital. Considering financing everything through equity would change the current 10.38% WACC to 11.5%. Lowering the ratio of the common stock will significantly lower the cost of capital. Our financial model allows us to evaluate the effect of the change of the weight on any component on the WACC.
PNC’s actual capital structure is very close to the target capital structure. The company is on the right track to grow and fulfill the expectation of the shareholders which is to pay dividend annually and increase the value of the common stock.
For the Spanish expansion PNC should borrow in Europe because the cost of borrowings is less for Euro-denominated debt (3.08% after tax). And this is the lowest cost of all for raising capital; therefore this is the best way to borrow. Although PNC can decrease unsystematic risk by obtaining loans domestically.
Introduction
Powerline Network Corporation (PNC) was founded in California in 1993.The company has grown globally in the electronics industry. They manufacture computer chips that can transmit digital signals over electric power lines to create network connections. It is a special chip that enables the computer to use the wiring of the house to build wireless connection with the network.
In the beginning the company was struggling because it couldn’t produce reliable chips. The design was good but the problems with manufacturing and the correction of these problems increased the price.
In 2002 PNC contracted a Taiwanese company that set aside the previously existing manufacturing problems. This way the business could set competitive prices and expand in the market. PNC started to grow really fast because lot of manufacturers begun to use their chips in electronic goods. Unfortunately there is no financial professional among the directors, so the CEO decided to conduct a series of presentation for the board of directors about financial management. This session will cover the issue of the cost of capital, financing the company. Despite of current expansion PNC’s growth rate expected to slow down to a sustainable level due to research and development expenses. The development is necessary to keep the competitive advantage and built modified chips that can be used in different products.
The series of presentation that initiated by Ray Reed, the CEO of the company aimed to educate the board of directors in financial decision making. This session will deal with capital budgeting, the cost of capital, capital structure, and project evaluation.
Sue Chung and her team were assigned to introduce the topic to the directors and educate them in a way that they will be able to make valuable decision in some current topics.
As we go along with the introduction of recent issues, the team will explain new definitions and concepts as well as offer alternative ways to solutions. Sue and the team will also present suggested solutions with their benefits and possible drawbacks.
Problems and Opportunities
Problems:
After solving the initial problem of manufacturing reliable chips PNC has been growing with an extraordinary rate. This growth has to be supported with a satisfying amount of capital. The problem is that none of the directors have this kind of financial experience, so they are unable to make a working financial plan and execute it. Sue and her team expected to help on this issue.
The other problems are originated from the main problem which is the lack of professional financial knowledge. The company just caught up with the industry in terms of sales and profitability, but still haven’t paid dividend. PNC plans to pay dividend every year with a 7.5% consistent dividend growth in the future. In order to do that the capital structure must be determined and profitable projects should be undertaken. When the right projects are chosen the necessary capital budget will be determined and the directors will have to find the best way to finance it.
Opportunities:
If we successfully solve the problems, they can turn into opportunities. Just some of the issues that can lead to opportunities if solved: should the company call any of their bonds? What type of stock (preferred, sinking fund, common) should the company issu if raising capital and what will it cost? How should they determine the weights on the components of the capital? What project should the company accept and how much budget it needs? Is there any advantage in borrowing in Europe, if yes, how can PNC benefit from it?
Methodology and Analysis
Problem 1
1. Although it has considered raising debt capital in Europe, PNC has actually raised all of its capital in the U.S. Based on the data in Table 1-a, what is a reasonable estimate of the company’s cost of debt for use in the WACC calculation? What do the results imply about the slope of PNC’s yield curve?
Cost Of Debt
The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is used most often. This is one part of the company's capital structure, which also includes the cost of preferred stocks and the cost of equity.
A company uses various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to the overall rate being paid by the company to use debt financing. The measure can also give investors an idea as to the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt.
To get the after-tax rate, simply multiply the before-tax rate by one minus the marginal tax rate (before-tax rate x (1-marginal tax)).
The rate is calculated in excel with the yield function (Appendix A). Giving all the necessary inputs, the result is the cost of debt before tax. A yield to maturity and a yield to call were calculated for both bonds. Since PNC has the option to call the bond 5 years from now, we choose the lower between the YTM and the YTC.
For bond B the YTC is 0.61% lower, so the company will retire those bonds. Assuming that PNC has the same amount of A and B bond, we calculate the before tax cost of debt by averaging “bond A YTM” and “bond B YTC”, which is 7.52%.
Because of the bond interest expense is tax deductible, we use the after tax cost of debt for WACC calculation which is 4.51%. (Table 1)
Table 1 Bond yields and cost of debt
tax rate / 40.00%QUESTION 1
Long-term Debt
A / B
Settlement / 9/15/2004 / 9/15/2004
Maturity / 7/1/2029 / 7/1/2029
R / 6.75% / 9.00%
Price / 88.75 / 112.25
Redemption / 100 / 100
Freq. / 2 / 2
Basis / 0 / 0
call date / 7/1/2009 / 7/1/2009
call price / 105 / 107.5
YTM / 7.78% / 7.87%
YTC / 10.63% / 7.26%
call or not? / 7.78% / 7.26%
average cost / 7.52%
After Tax / 4.51%
cost of debt / 4.51%
Yield Curve
A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.
The yield curve for PNC’s stock shows (Figure 1) that the short term and the long term rate of return on the bonds are almost equal, which means the company is stable so there risk involved in the long term is low.
Figure 1, PNC’s yield curve
.
Problem 2
2. PNC also raises capital with preferred stock. Data on preferred stock are also provided in Table 1. If PNC finances with preferred, which type should it choose, and what would its cost be for the WACC calculation? Is the relationship between the yields on the two preferreds, and between the preferreds and debt, consistent with their risks to investors? Would an increase in the percentage flotation cost have a greater impact on the sinking fund or perpetual preferred?
The cost of existing preferred stock can be calculated as shown below:
Where: Dps is the dividend as the percentage of the face value
and Pps is the current market price.
The cost of new preferred stock has to contain the flotation cost:
Where F is the flotation cost in percentage of the face value. (Cost of Capital, 2006)
To calculate the cost of the optional sinking fund, we need to calculate the relevant cash flows associated with the issuance and financing of the fund. The sinking fund would require the company to retire 10 % of the original shares each year after issuance and the issuance would have 2% flotation cost.
Table 2 below illustrates the cash flow.
Table 2 sinking fund cash flow
2004 / 2005 / 2006 / 2007 / 2008 / 2009 / 2010 / 2011 / 2012 / 2013 / 20140 / 1 / 2 / 3 / 4 / 5 / 6 / 7 / 8 / 9 / 10
$98.00
$100.00 / $90.00 / $80.00 / $70.00 / $60.00 / $50.00 / $40.00 / $30.00 / $20.00 / $10.00
$(10.00) / $(10.00) / $(10.00) / $(10.00) / $(10.00) / $(10.00) / $(10.00) / $(10.00) / $(10.00) / $(10.00)
$(5.25) / $(4.73) / $(4.20) / $(3.68) / $(3.15) / $(2.63) / $(2.10) / $(1.58) / $(1.05) / $(0.53)
$98.00 / $(15.25) / $(14.73) / $(14.20) / $(13.68) / $(13.15) / $(12.63) / $(12.10) / $(11.58) / $(11.05) / $(10.53)
Row 1: Year
Row 2: Period
Row 3: Net proceeds from sale
Row 4: Balance of Risky Investment outstanding
Row 5: Retirement payments:
Row 6: Total preferred dividend payments:
Row 7: Net cash flow to company:
IRR = Cost to company (pre-tax): 5.70%
(for the excel function IRR, please turn to appendix B)
As results we get the followings:
Cost of existing preferred stock: 6.01%
Cost of new preferred stock: 6.13%
Cost of the sinking fund: 5.70%
PNC should choose to finance it’s capital with the sinking fund, and so that is the value we use for the WACC calculation (5.70%).
Is the relationship between the yields on the two preferreds, and between the preferreds and debt, consistent with their risks to investors?
Yes it is.
The sinking fund has lower risk so the expected return differs accordingly.
Preferred stock is more risky, because the company not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.
Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.