Case3

4B

ACE REPAIR,INC.

Directed

In 1978, while he was taking a course on entrepreneurship as a business student at a large state uni-versity, Peter Vanderhein wrote a term paper on the management of auto repair shops. Peter’suncle owned a repair shop, and Peter had worked for him as well as for several other body shopswhen he was in high school and college. Once he began taking business courses, Peter came to rec-ognize that most shops were inefficient, especially in the way they managed their inventories andreceivables. This inefficiency resulted in excessive stocks of some items, shortages of others, fre-quent stock-outs, late payments, bad debt losses, and many dissatisfied customers. Still, in spite oftheir inefficiency, the average repair shop appeared to be fairly profitable. Peter concluded that anopportunity existed to buy inefficient auto repair shops, consolidate them into a concern that waslarge enough to use computers to manage inventories and receivables, and thereby increase prof-itability sharply. He also felt that volume discounts, improved training, and other economies of scale,would give a further boost to profits.

With encouragement from his family and professors, Vanderhein decided to put his theory tothe test, and in 1979 he started Ace Repair, Inc. Ed Adams, Peter’s uncle, wanted to retire, and heagreed to sell out subject to a “purchase money mortgage” which would be repaid from the busi-ness’ cash flow. Peter was also able to borrow $100,000 from some family friends, and he arrangeda $50,000 bank loan secured by the business’ assets. He used this $150,000 to purchase computersand software, and to train his employees in the use of the new equipment.

Adams agreed to help Peter set things up and then help the shop’s employees adapt to thenew procedures. Everything went well, and profits rose even more rapidly than under Peter’s opti-mistic forecasts. By early 1981, Peter felt that the bugs were out of his shop management system, sowith Ed’s help, he began to look seriously for additional acquisitions. He took over two new shopslater in 1981, sending employees from the first shop to help run the new ones. The operations of theacquired shops were as successful as those of the first shop. He bought three additional shops in 1982,and acquisitions continued at an increasing pace thereafter. By 1995, Ace Repair controlled a totalof 243 shops located throughout the Midwest.

Peter used a mix of securities—common stock, preferred stock, and first mortgage bonds—inaddition to retained earnings to finance acquisitions and open de novo shops, while using trade creditplus bank loans to help meet working capital needs. Peter has also considered the use of convertiblesecurities, but to date no convertibles have been issued. Currently, Ace has 6.2261 million com-

Copyright ©1994. The Dryden Press. All rights reserved.

Case:04BDCost of Capital

mon shares outstanding, of which Peter owns 17 percent. The stock sells in the over-the-counter mar-ket for $30.50 per share.

Since the company’s inception, Peter has been directly and tirelessly involved in all facets ofthe business. He is satisfied with the service his shops provide, with the company’s inventory andreceivables management, and with the marketing aspects of the business. However, he has becomeincreasingly uneasy about the finance function, in which he has no special expertise. The controllerhas overseen most financial matters, but with the rapid growth in the scope and size of the busi-ness, financial decisions have become increasingly complex. Further, competition from large cor-porations such as Sears, Wal-Mart, and auto dealerships has been increasing. So, by 1995,Vanderhein concluded that to ensure continued success, he must establish a finance group that wasas competent and sophisticated as those of his competitors. Therefore, in late 1995, he hired AdamNaranjo, a senior financial executive with a major retail chain, as vice president and chief financialofficer (CFO).

Naranjo began by reviewing the existing capital investment procedures. After going over theprocedures manuals and the supporting analyses for recent capital investment decisions, he con-cluded that the overall procedures were generally appropriate: The firm relied on discounted cashflow criteria to arrive at accept/reject decisions for most projects; it estimated future cash flows onan incremental basis; and it discounted cash flows at the firm’s weighted average cost of capital(WACC). However, the estimate of the cost of capital itself was questionable.

In the most recent capital budgeting exercise, at year-end 1995, the controller used a before-tax debt cost of 10 percent, which was equal to the coupon rate on Ace’s last (1993) long-term firstmortgage bond issue. These bonds are rated single A, will mature in 17 years, and can be called in3 years. For the cost of equity, the controller used the year-end earnings yield (E/P) of 7.5 percent,based on an earnings per share of $2.30 and a share price of $30.50. His justification for using theE/P yield was that since investors were getting $2.30 of earnings for a $30.50 investment, theywere willing to accept a 7.5 percent rate of return on their money. Also, the controller noted that ifthe company could sell stock for $30.50 per share and then invest the proceeds at a 7.5 percent rateof return, earnings per share would remain at $2.30. He also noted that this 7.5 percent is an after-taxcost, and it is below the after-tax cost of debt. Of course, the controller wants the company to sellstock only to finance projects that will earn more than the 7.5 percent cost of equity, hence willincrease earnings per share. Table 4 (2) contains the quotation of the company’s preferred stock. Thissecurity has a par value of $100 and new issues would have a flotation cost of $2.50 per share.

Given estimates of the capital components’ costs, the controller calculated the WACC on thebasis of weights as determined from the balance sheet shown in Table 2. These book value weightsdiffer from the market value weights and from the company’s target capital structure as reported inTable 4, part 11.

In early January 1996, Naranjo decided to hire your consulting firm to conduct a cost of cap-ital analysis and to make a critical evaluation of the current estimation procedures. Naranjo providedyou with the financial statements given in Tables 1 and 2, plus the information in Tables 3 and 4.

You must critique Ace’s current procedures for estimating the costs of debt and equity, andthen use the data to estimate Ace’s component costs of capital, WACC, and marginal cost of capi-tal schedule. You must also decide whether to use your estimate of the marginal weighted averagecost of capital as the hurdle/discount rate for all of the firm’s projects.

Naranjo is also interested in your views on the weights used to calculate the WACC. The con-troller has been using book weights based on the actual capital structure, but considering long-termcapital only. His reasoning was that this is the way the capital used for capital budgeting purposeshas actually been raised, and also that Moody’s, S&P, and all security analysts whose reports he hasseen focus on actual capital structures based on actual accounting statements. He chose not to use mar-ket value weights in part because investors apparently do not focus on market value weights, andalso because market value weights would be unstable, hence would result in a fluctuating WACC, andas a result would destabilize the capital budgeting process. He has toyed with the idea of using the

Case:04BDCost of Capital

target capital structure weights, but he correctly pointed out that the targets have never been attained,and there is no reason to expect them to be attained anytime soon. Naranjo wants your opinion on (1)what weights should be used, and (2) how much difference the choice of weights would make inthe calculated WACC.

If Naranjo likes your report—if he thinks it is logical, technically correct, and well presented—he will hire your firm for other consulting assignments and recommend you to his friends. Hemight even offer you the job as treasurer of Ace Repair. In any event, a well-received report will giveyour career a big boost, so you want to do a good job. To help structure your analysis and report,answer the following questions.

QUESTIONS

1.a.Discuss the specific items of capital that should be included in the WACC.

b.The comptroller currently finds the weights for the weighted average cost of capital(WACC) from information from the balance sheet shown in Table 2. Compute the bookvalue weights that the comptroller currently uses for the company’s capital structure. c.Based on the suggestion that the focus should be on market values, compute the weightsof debt, preferred stock, and common stock.

d.Are book value or market value weights better for calculating the firm’s weighted aver-age cost of capital?2.a.Critique Ace Repair’s current method of estimating its before-tax cost of debt.b.Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity?3.a.b.c.d.

What is the best estimate of Ace’s cost of debt?

Should flotation costs be included in the component cost of debt calculation? Explain. Should the nominal cost of debt or the effective annual rate be used? Explain.

How valid is an estimate of the cost of debt based on the yield to maturity of Ace’s debt(ignore the call provision in 3 years) if the firm plans to issue 20-year long-term debt? e.What other methods could be used to estimate the cost of debt if, for example, Ace’s out-standing debt had not been traded recently?

4.a.What is Ace’s cost of preferred stock?

b.Ace’s preferred stock is more risky to investors than its debt, yet the before-tax yield onits preferred is lower than the yield on A-rated debt issues. Why does this occur?

c.What if Ace’s preferred stock required the establishment of a sinking fund that calls forthe retiring 5 percent of the initial issue of preferred stock each year at par? How wouldthe cost of preferred stock change and be handled in the WACC calculation?5.a.Why is there a cost associated with retained earnings?

b.What is Ace’s cost of retained earnings, based on the CAPM approach and the analysts’long run forecast rate of growth?

c.Why might one consider the T-bond rate to be a better estimate of the risk-free rate thanthe T-bill rate? Why might one argue for the use of the T-bill rate?

d.How do historical betas, adjusted historical betas, and fundamental betas differ? WouldAce’s historical beta be a better or a worse measure of its future market risk than the his-torical beta for a portfolio would be for the portfolio’s future market risk? Explain.

Case:04BDCost of Capital

e.What are some alternative ways to obtain a market risk premium for use in a CAPM cost-of-equity calculation? Discuss both the possibility of obtaining estimates from outsideorganizations and also ways which Ace could calculate a market risk premium itself. 6.a.What is Ace’s discounted cash flow (DCF) cost of retained earnings?

b.Suppose Ace, over the last few years, has had an 18 percent average return on equity(ROE) and has paid out 20 percent of its net income as dividends. Under what conditionscould this information be used to help estimate the firm’s expected future growth rate, g?Estimate ksusing this procedure for determining g.

c.What was the firm’s historical dividend growth rate using the point-to-point method?Using the linear regression method?7.Use the bond-yield-plus-risk-premium method to estimate Ace’s cost of retained earnings.8.Based on all the information available, what is your best estimate for ks? Explain how youdecided what weight to give to each estimating technique.9.What is your estimate of Ace’s cost of new common stock, ke? What are some potentialweaknesses in the procedures used to obtain this estimate?10.a.Compute Ace’s WACC’s based on the company’s target capital structure and construct

the marginal cost of capital (MCC) schedule. How large could the company’s capitalbudget be before it is forced to sell new common stock? Ignore depreciation at this point.b.Would the MCC schedule remain constant beyond the retained earnings break point, nomatter how much new capital it raised? Explain. Again, ignore depreciation.

c.How does depreciation affect the MCC schedule? If depreciation were simply ignored,would this affect the acceptability of proposed capital projects? Explain.11.Should the corporate cost of capital as developed above be used for all projects? If not, what

type of adjustments should be made?

Case:04BDCost of Capital

TABLE 1

Ace Repair, Inc.: Income Statementfor the Year Ended December 31, 1995

(In Thousands of Dollars)

Net sales

Cost of goods soldGross profit

Admin and selling expDepreciation

Miscellaneous expensesTotal operating expEBIT

Interest on ST loansInterest on LT debtTotal interest

Before-tax earningsTaxes (40%)

Earnings bef. pref. div.Preferred dividends

Net income available to commonDividends on common stockAdditions to retained earningsEPSDPS$400,467$320,477$ 79,990$ 34,040$ 4,080$ 10,132$ 48,252$ 31,738$ 3,016$ 3,600$ 6,616$ 25,122$ 10,049$ 15,073$ 800$ 14,273$ 2,855$ 11,418$ 2.30$ 0.46

Case:04BDCost of Capital

TABLE 2

Ace Repair, Inc.: Balance Sheet

December 31, 1995(In Thousands of Dollars)

Assets

Cash and securitiesAccounts receivableInventory

Current Assets

Land, buildings, plant, and equipment

Accumulated depreciationNet fixed assets

$ 5,000 46,28674,065$125,351 $106,463(13,388)$ 93,075

Preferred stockCommon stockRetained Earnings

Total common equityTotal liab. and equity

10,00020,00059,297$ 79,297$218,426Liabilities and Equities

Accounts payable S-T bank loansAccruals

Current liabilities Long-term bonds Total liabilites

$ 38,98735,48014,662$ 89,12940,000$129,129

Total assets$218,426TABLE 3

Selected Ratios, Ace Repair, Inc.

Current ratioQuick ratio

Total debt/total assets

Long-term debt/long-term capitalTimes interest earnedInventory turnoverDays sales outstandingTotal assets turnoverProfit marginP/E ratio

Market/book ratioPayout ratio1.41 times0.58 times59.1%30.9%

4.80 times5.41 times41.61 days1.83 times3.56%13.26 times2.39 times20.0%

Case:04BDCost of Capital

TABLE 4

Selected Data on Ace Repair, Inc.

1.The end-of-year bond quote on Ace’s long-term, semiannual bond as reported in the finan-cial press is as follows:

BondsACE10s12

Cur Yld8.3

Vol30

Close120.90

Net Chg+1⁄2

These bonds will become callable in 3 years at a price of $1,100.

2. End-of-year quotes on Ace’s common and perpetual preferred stock were as follows:

52 Weeks

Hi31.5110_

Lo26.598_

StockAceAcepf

SymACERACEP

Div0.468.00

Yld

%1.57.6

PE13.3—

Vol

100s25667

Hi 31105

Lo30102_

Close30105

Net

+1⁄2+3⁄4

Chg

3.End-of-year quotes on long-term treasury bonds were obtained from The Wall Street Journal:Coupon Rate10 3⁄810 5⁄87 5⁄8

MaturityMo. /Yr.Dec. 05Dec. 15Dec. 25

Bid 133:06144:08113:22Asked 133:10144:10113:24Chg–3–6–6Ask Yld6.276.616.57

4.End-of-year quotes on treasury bills were also obtained from The Wall Street Journal:

MaturityMar 30 June 29Sept 19

Daysto Mat.

90 181265

Bid 5.44 5.405.31

Asked 5.42 5.385.29

Chg0 +.010

Ask Yld5.595.61 5.55

5.Ace’s federal-plus-state tax rate is 40%.

6.The firm’s last dividend (D0) was $0.46. Here are the earnings and dividends per share overthe last 5 years:

Case:04BDCost of Capital

TABLE 4 (continued)

Selected Data on Ace Repair, Inc.

Year 19911992199319941995DPS $0.12 0.30 0.30 0.33 0.46 EPS$0.60 0.84 1.17 1.64 2.30

Some analysts may expect the same rate of growth in the future as in the past, while othersprobably expect it to decline as new competition enters the market. The average of all pub-lished analysts’ “long run” forecasts—which are generally not specific but are often for thenext 5 to 7 years—is a rate of about 16 percent.

7.A prominent investment banking firm recently estimated that the market risk premium is 6percentage points over 30-year Treasury bonds. Security analysts have asked portfolio man-agers what risk premium they demand on a given company’s stock over bonds. The analystshave compiled results which generally indicated a 3–5% premium above bond returns. Fur-thermore, based on historical data, Ibbotson Associates has found that the return premium ofstocks over T-bonds has averaged about 7.0 percent from 1926 through 1995. Ace’s histori-cal beta as measured by several analysts is 1.3.8.The going interest rate on an index of A-rated long-term corporate bonds is 8.0 percent.9.Ace is forecasting earnings of $17,127,000 and depreciation of $4,500,000 for 1996. As inthe recent past, about 20 percent of earnings will be paid out as dividends.10.Ace’s investment bankers believe that a new issue of common stock would require total

flotation costs—including underwriting costs, market pressure from increased supply, andmarket pressure from negative signaling effects—of 30 percent.11.Several years ago Vanderhein wrote into the company’s strategic business plan the state-ment that Ace’s target capital structure calls for 30 percent long-term debt, 5 percent pre-ferred stock, and 65 percent common equity. However, he was not sure whether the targetshould be based on book or market values. A professor who consulted with the companysuggested that the focus should be on market values, but he noted that most bond ratingagencies, security analysts, and corporate executives focus on book values.