H. J. Heinz Estimating the Cost of Capital in Uncertain Times Harvard Case Solution & Analysis

H. J. Heinz Estimating the Cost of Capital in Uncertain Times Case Study Solution

Usage of WACC

There are a lots of usage of WACC that can be used by Heinz. Firstly, WACC is used to assess the return on invested capital (ROIC) for comparison the performance of the company either they are earning enough to compensate their cost of capital or not. Secondly, WACC is also used for the calculations of economic value added (EVA). Thirdly, it plays a key role for investors to invest in particular businesses. If WACC will be high then investors think that the company is more risky, so, at that level investors avoid to invest in risky company. Fourthly, WACC represents the minimum rate of return that a company promise to pay its investors and produce value for their investors. Fifth one plays the important role in decision making. If company is going to invest in any project, it will compare the return from that project with its WACC, if the return will higher than WACC, company will accept that project otherwise it will reject it. (Investopedia, n.d.)

Effects of Changes in Interest Rates

The total debt of company is more than the equity of the company which is indicating that company has high risk. This high risk gives an advantage to the company in the form of tax savings. The WACC of company which is comprising of 78% of debt and 22% of equity increases the interest cost of the company. The interest cost is subtracted from the earning and company faced low income taxes because of less income shows after deduction of interest cost.

The weighted average cost of capital of a company changes with an increase in the interest rates so in case if interest rates increases than it is for sure that the cost of capital will also rise. Similarly, cost of capital declines with the decrease in the interest rates. However, if high interest rate increases further in long term then it will affect the company’s profitability as the company is highly leveraged by debt. If interest decrease at the time of long term debt maturity the company can gain high profitability as low interest rate will be paid by the company.

Comparing Heinz with Other Comparable Firms

After analyzing the cost of capital structure of other comparable data, it is observed that the only company which has similar capital structure with Heinz is Campbell Soup. The Beta which is company’s specific risk used in calculating the cost of equity is assumed to be 0.65 for Heinz and 0.55 for Campbell soup. This assumption indicates that Heinz cost of equity is higher which might be resistant to its growth. On the other hand, both companies share high debt capital structures and are enjoying high tax savings due to the increased interest cost as compared to the other firms with low debt in capital structure.

Heinz in comparison with other firms like Kraft and Del Monte comprises of high quality long term with less fluctuations in the interest rates and high rating in debt, whereas Kraft and Del Monte acquire low grade debt in comparison with Heinz. This gives an advantage to Heinz as low interest fluctuations result in low interest cost. Heinz also attains the advantage over Kraft and Del Monte because of high debt in capital structure is providing high tax savings to Heinz.
Exhibit-1: Calculations

Capital Asset Pricing Model (CAPM)
Expected return for cost of equity=rf + B(rm - rf)
rf = risk free rate=3.69%
rm = market risk premium=7.50%
B = beta for Heinz=0.65
Expected return for cost of equity=6.17%
weight
Short term debt + current portion of LTD=    452,7085.42%
LTD and other non-current liabilities=  6,007,16371.96%
Equity=  1,887,82022.61%
Total=  8,347,691100.00%

 

Bond Valuation
Semiannual bond maturing in 2032
Face value=$100
Coupon Payment=$3.38
Current price of bond=$116.90
Yield to maturity=5.424%
year remaining=22
Periods remaining=44
116.915226
Short term borrowing cost=1.20%

 

Weighted average cost of capital (WACC)
WACC=Cost of equity * weight of equity + cost of LTD * weight of LTD + cost of STD * weight of LTD
WACC=5.363%
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H. J. Heinz Estimating the Cost of Capital in Uncertain Times

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