Cost of Capital Analysis

1
Cost of Capital Analysis

• Colette Ruff
• Timothy Coffing
• Brian Kaplan

February 29, 2000
2
Overview

• Company background
• Weighted Average Cost of Capital (WACC)
• Weight of debt
• Weight of equity
• Cost of debt
• Cost of equity
• Conclusion

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Company Background

• IBMs beginning.
• IBMs transformation over time.
• IBM today.
• IBMs future opportunities.

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Consolidated Statements
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Weights to use in WACC

• Presented
• by
• Colette Ruff

5
Weights to use in WACC

• Book Value
• Debt
• Equity
• Market Value
• Debt
• Equity
• IBMs Capital Structure

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Weighted Average Cost of Capital

• WACC Wd kdat We ke
• Wd weight of debt used to total capital
• We weight of equity used to total capital
• Kd cost of debt
• Ke cost of equity
• dat after tax

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Book Value of Long Term Debt

• Book Value-from balance sheet in millions
• Long-Term debt 15,508
• Other Liabilities 8,000
• Deferred Income Taxes N/A
• Total BV of Debt 23,508

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Consolidated Statements
8
Market Value of Debt

• Market Value
• Market Value assumed to be equal to the Book
  Value of debt.
• Total Market Value of Debt 23,508

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Consolidated Statements
9
Book Value of Equity

• Book Value (from balance sheet in millions)
• Common Stock 10,121
• Retained Earnings 10, 141
• Treasury Stock
  (133)
• Employee Benefit Trust (1,854)
• Accum. Gains/Losses 911
• Total BV of stockholders equity 19,186

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Consolidated Statements
10
Market Value of Equity

• Market Value of Common Equity is found by
• Current Stock Price/Share Total of shares
  outstanding
• 184.38 916.9 shares
• 169,058Total MV of Common Equity

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Consolidated Statements
11
Book vs. Market Value

• Book Book
  Market Market
• LT Debt 15,508 36.3
  15,508 8.1
• Other Liab. 8,000 18.7
  8,000 4.1
• Total Debt 23,508 55.1
  23,508 12.2
• Total Equity 19,186 44.9
  169,058 87.8
• Total Capital 42,694 100 192,566
  100
• Note All values are in millions of dollars.

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Consolidated Statements
12
Book vs. Market Value
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Consolidated Statements
13
IBMs Target Capital Structure

• Market Value Weights for IBM
• Wd 12.2
• We 87.8
• - We use market value instead book value because
  it is more relevant. It tells what the firm is
  worth today. Book value is the historical cost.
  

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Consolidated Statements
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The Cost of Debt

• Presented
• by
• Colette Ruff

15
The Cost of Debt

• Determining the Kd
• YTM on a sample of IBM outstanding bonds.

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Determining the Cost of Debt

• Kdat Kd ( 1 - tax rate )
• Kd average yield of IBM long term bonds from
  the SP Bond Guide
• tax rate IBMs corporate tax rate
• Tax Rate 30 (from notes)

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Determining Tax Rate

• (Taken from 1998 Income Statement)
• Income before income tax 9,040
• Net Income
  6,328
• Income before income tax ( 1-tax rate ) Net
  Income
• 9040 ( 1 - tax rate ) 6,328
• Tax rate 30

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Consolidated Statements
18
Yield to Maturity on a Sample of IBMs
outstanding bonds

• Bond Yield
• Deb 8.375s2019 7.35
• Deb 7s2025
  7.26
• Deb 6.22s2027 6.45
• Deb 6.5s2028
  7.30
• Deb 7s2045
  7.46
• Kd ( 7.357.266.457.307.46 ) / 5
• Kd 7.164

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After Tax Cost of Debt

• kdat kd (1- Tax Rate)

• Kdat 7.164 ( 1 - 30 )
• Kdat 5.015

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The Cost of Equity

• Presented by
• Brian Kaplan
• Timothy Coffing

21
The Cost of Equity

• Bond yield plus risk premium
• Market Capitalization
• CAPM
• Dividend Growth Model

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Bond Yield plus Risk Premium

• ke Bond Yield Risk Premium

Average yield of IBM long term bonds (kd)
Estimated range of companys risk

• Ke 7.164 4 11.164
• Ke 7.164 5 12.164
• Ke 7.164 6 13.164

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Market Capitalization
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Market Capitalization
Average Annual Return 26-93
Average CPI 26-93
Inflation Expectation
Ke
-

Ke 11.2 - 3.24 1 8.96
Ke 11.2 - 3.24 2 9.96
Ke 11.2 - 3.24 3 10.96
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Average CPI Spreadsheet
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Capital Asset Pricing Model

• ke Risk Free Rate Beta (Market Risk Premium)
• - krf is the risk free rate taken from a 30
  year treasury bond.
• - b is an average of the monthly historical
  betas which measures the riskiness of a
  stock.
• - MRP is the risk free rate subtracted from the
  average market risk .

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Risk Free Rate

• krf Yield to Maturity on a 30 year
  treasury bond on December 31, 1998
• krf 5.082

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Beta
Average ? 0.786
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Market Return

• Market return is calculated by taking the average
  annual returns on the SP 500 from 1961 1997.
• Rm 12.48

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Market Risk Premium

• Market Risk Premium is the risk free rate
  subtracted from the return on market
• MRP 12.48 - 5.082 7.398

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Capital Asset Pricing Model

• ke Risk Free Rate Beta (Market Risk Premium)
• ke 5.082 0.786 (7.398)
• ke 11.63

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Dividend Growth Model

• Presented
• by
• Timothy Coffing

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Dividend Growth Model

• ke ( D1 / P0 ) g
• D1 Next years dividend
• P0 Current Stock Price
• g expected growth rate

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Dividend Growth Model

• Estimating Ke assuming
• g dividends g stock price
• Preferred Method
• Comfort with estimating dividend growth.
• Fluctuating historic growth.

FOR MORE INFO...
Excel DCF Growth Model
34
Dividend Growth Model
FOR MORE INFO...
Excel DCF Growth Model
35
The Cost of Equity

• Market Capitalization
• ke 8.96 - 10.96
• Bond Yield plus Risk Premium
• ke 11.164 - 13.164
• Capital Asset Pricing Model
• ke 11.63
• Dividend Growth Model
• ke 11.13 - 15.3
• ke 8.96 - 15.3

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Final WACC

• WACC Wd kdat We ke
• WACC 12.2 5.015 87.8 8.96 8.45
• WACC 12.2 5.015 87.8 15.3 14.05

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• Thank you for your time and we will be happy to
  answer any questions.

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Consolidated Statements
Excel DCF Growth Model
38
Works Cited

• IBM. The Story of IBM. IBM History.
  http//www.ibm.com/ibm/history/.
• Gerstner Jr., Louis V. Letter to Shareholders.
  IBMs 1998 Annual. Reports. http//www.ibm.com/an
  nualreport/1998/letter/ibm98arlsen01.html.
• .
• .

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