Mini Project 2

SAMPLE REPORT FOR MP2

Cost of Capital calculation for company name & logo

Submitted to: Class, professor

By: student name

On: date

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

Company Profile Source: https://finance.yahoo.com/

Company name: McDonald’s Inc.

Ticker: MCD

Sector: Consumer Cyclical Industry: Restaurants

Cost of capital components Cost of debt This company has had an implied historical cost of debt around 3%

Cost of debt, historical costs 12/1/2017 12/1/2016 12/1/2015 12/1/2014 12/1/2013

Long-term debt 29536400 25878500 24122100 14989700 14129800 Interest paid 885200 873500 640800 573200 532700

Implied interest rate 3.00% 3.38% 2.66% 3.82% 3.77%

However, historical cost is not relevant. What we need is what the market demands for the debt of this company, which is equal to the cost of new debt issues.

MCD has a Moody’s rating of Baa1 and a S&P’s rating of BBB+

https://www.moodys.com/credit-ratings/McDonalds-Corporation-credit-rating-479500

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

https://www.standardandpoors.com/en_US/web/guest/ratings/entity/-/org- details/sectorCode/CORP/entityId/101460

McDonald’s has several issues of debt with maturities ranging from 2020 all the way to 2048

The reference for cost of capital calculations is 10 years. Looking at the different issues we see two of them maturing around 2029

http://finra-markets.morningstar.com/BondCenter/Results.jsp

Average yield for these two issues is 3.6%, which is our estimate for new debt

Cost of preferred stock This company doesn’t use preferred stock to finance its operations so we don’t need to estimate Rp.

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

Cost of equity We’ll be using three methods to develop our estimate for the cost of equity

DCF approach

This method can only be used for dividend paying companies. The cost of equity is defined as the sum of the dividend yield and the expected growth in dividends.

Dividend yield is directly taken from a website that displays Forward yield

https://finance.yahoo.com/quote/MCD?p=MCD

For MCD, it is estimated to be 2.57%

To estimate growth in dividends, we can use 3 sources:

First is the analysts’ average expectation for earnings growth in the next 5 years.

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

https://finance.yahoo.com/quote/MCD/analysis?p=MCD

It is important to note that sometimes analysts are too optimistic and produce estimates that are too high. That is why it is important to use two more methods

Historical growth of dividends

Growth of dividends

Recent growth Last year

Last 2 years

Last 3 years

Last 5 years

Last 7 years

Last 10 years

Dividends declared per common share 6.1% 5.5% 5.3% 4.2% 7.8% 9.8%

From the trend in the last 2 years we could say that it will be above 6%. However, MCD has had negative equity in the last 2 years, indicating high levels of debt, which makes me a bit more conservative in my forecast. My number is 4.2%, which is the average growth in the last 5 years.

The last method to estimate dividend growth is the concept of sustainable growth rate

The formula used is ROE x (1 – Dividend Payout ratio)

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0%

Dec-99 Dec-02 Dec-05 Dec-08 Dec-11 Dec-14 Dec-17

Growth Dividends declared per common share

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

Historical payout ratio 12/1/17 12/1/16 12/1/15 12/1/14 12/1/13 12/1/12 Net income 5192300 4686500 4529300 4757800 5585900 5464800 Common stock dividends 3089200 3058200 3230300 3216100 3114600 2896600

Payout ratio 59.5% 65.3% 71.3% 67.6% 55.8% 53.0%

ROE 12.8% 7.5% 6.2% 6.6%

Sustainable growth NA NA 3.7% 2.4% 2.7% 3.1%

Taking numbers from the statement of cash flows we see that payout has been between 35 and 71%, sustainable growth has moved between 2.4 and 3.7 percent. Excluding the most recent 2 years we get an average of 3% sustainable growth

From the 3 growth estimates and the dividend yield we get our first estimate for the cost of equity

Three estimates of g Analysts earnings estimate 6.55% My estimate based on historical growth 4.20% Sustainable growth 3%

Average 4.56%

Dividend yield 2.57%

Rs 7.13%

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

CAPM approach

Formula for the cost of equity is Rs = Rrf + Beta * MRP

Market risk premium is estimated to be 5.5%. For Risk free rate we use the 10 year Treasury bond, which is 2.58%

http://finra-markets.morningstar.com/BondCenter/Default.jsp

For beta we use different sources to estimate it

First, based on historical prices, we calculate returns for the stock and the S&P 500 and run the regression line to estimate beta. Our calculations yield a beta of 0.47

Using three financial websites to obtain market beta we get an average value

y = 0.4752x + 0.011

-0.1

-0.05

0

0.05

0.1

0.15

0.2

-0.15 -0.1 -0.05 0 0.05 0.1

Ret MCD

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

Average beta estimate

Using 5 years of data 0.475 Yahoo (3 years) 0.39 MSN Money 0.52 Reuters 0.65

Average beta 0.509

Then the estimate of Rs is obtained

Average beta estimate 0.509

Market Risk Premium 5.50%

Risk free rate 2.59% Rs 5.39%

Risk and return of the stock It is important to note that when we estimated historical returns for the most recent 5 years we see that MCD has produced very high returns compared to the market but with a very low beta. This indicates that MCD exceeded market expectations. Looking at total risk of the stock (SD) we only see a small increase in risk.

S&P 500 MCD Yearly average 8.7% 17.4%

Yearly SD 11.2% 13.9% Beta 1.0 0.51

Rd plus a risk premium approach

The third method to obtain Rs is to use the estimate of the cost of debt (Rd) and add a risk premium.

The historical risk premium between the debt and the equity of companies is about 4%

Rd 3.59% Risk Premium 4%

Rs 7.59%

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

Capital Structure Given that this company doesn’t have preferred stock, we only need to estimate Wd and Ws. MCD did have preferred stock in the 1990s but they cancelled in 1997 and they haven’t used this method of financing their operations.

Another estimate we need to obtain is the effective tax rate for the firm

We use 5 years of data and calculate the average

Tax rate 12/1/2017 12/1/2016 12/1/2015 12/1/2014 12/1/2013 Income taxes paid 2786300 2387500 1985400 2388300 2546000 Income before provision for income taxes 8573500 6866000 6555700 7372000 8204500 Implied rate 32.5% 34.8% 30.3% 32.4% 31.0%

Average tax rate last 5 years 32.2%

Using book values We observe that since equity is negative in recent years, we can’t estimate weights for those years

Capital structure Based on book value of firm

12/1/2017 12/1/2016 12/1/2015 12/1/2014 12/1/2013 Long-term debt (D) 29536400 25878500 24122100 14989700 14129800 Total shareholders' equity (deficit) (E) -3268000 -2204300 7087900 12853400 16009700 Value of firm (V) NA NA 31210000 27843100 30139500 D/V NA NA 77.3% 53.8% 46.9% E/V NA NA 22.7% 46.2% 53.1% Average for last 5 years D/V 59.3% E/V 40.7%

Using market values The estimation of weights using market values depends on the day that stock price is measured. It is important to decide the day in which market capitalization is measured. A good practice is to measure market cap at the end of the fiscal year. Given MCD has a fiscal year ending in December we’ll use end of December 2018 to estimate market cap.

In addition to the calculation at the end of 2018, we include a historical calculation of weights based on stock prices in December 2014, December 2015, December 2016 and December 2017

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

Capital structure Based on market value of firm Calculating historical market equity 12/1/2017 12/1/2016 12/1/2015 12/1/2014 Long-term debt (D) 29536400 25878500 24122100 14989700 Year-end shares outstanding 794100 819300 906800 962900 Stock price end of year 172.12 121.72 118.14 93.70 Market capitalization (E) 136680488 99725197 107129351 90223727 Value of the firm (V) 166216888 125603697 131251451 105213427

D/V 17.8% 20.6% 18.4% 14.2% E/V 82.2% 79.4% 81.6% 85.8% Average for last 4 years D/V 17.7% E/V 82.3% Market capitalization at the close of the most recent fiscal year Based on market value of firm Dec-18 Debt at the close of the fiscal year 31075300 Stock price at close of fiscal year 177.57 Shares outstanding, most recent 765320 Market capitalization (E) 135897878 Value of the firm (V) 166973178 D/V 18.6% E/V 81.4%

It is important to note that though Mergent data ends in 2017, the financial statements for 2018 are available now. Yahoo Finance was used to retrieve the most recent amount for long-term debt and for the number of shares outstanding.

FINC 6352 – Financial Management Sample MP2 – Cost of Capital Calculation for MCD

Weighted Average Cost of Capital The calculations of WACC are shown for both methods of calculating weights

Weighted Average Cost of Capital Tc 32.2% Rd 3.59% 1) DCF Rs 7.13% 3) Rd + RP 7.59% Avg Rs 7.36% Calculating capital structure with book values D/V 59.3% E/V 40.7% Estimate of WACC 4.44% Calculating capital structure with market values D/V 18.6% E/V 81.4% Estimate of WACC 6.45%

As we can see from the results, the WACC obtained with market values is higher than that obtained using book values. This is normally the case given that Rs is normally higher than Rd and Ws is typically lower when we use book values.

The final WACC estimate obtained with market values is more than 2% higher than the one obtained using book values.