Royal Mail pIc: Cost of Capital

As Hillary Hart, senior financial analyst at the British postal s~rvice company Royal Mail
pIc (Royal Mail), approached company headquarters near Blackfriars Bridge in London,
she reflected on the momentous nature of the seven years she had spent in that building.
During that time, the company had faced important changes in broad demand for letters
and parcels, significant restructuring of government regulation, competitive entry into its
long-standing monopoly position, deep workforce cuts, wide-scale labor negotiations
and strikes, and, lastly, the transition from 500 years as a government-owned enterprise
to a massive for-profit company traded on the London Stock Exchange.
Now on July 21, 2015, Hart had an upcoming meeting with several senior managers
of the company. Central to the meeting was an evaluation of the cost of capital for Royal
Mail. The cost of capital had become a point of discussion for two reasons. First, since
privatization, Royal Mail was increasingly looking to shed its government-based deci-
sion-making policies of the past for a more market-based orientation. The adoption of an
investor-oriented cost-of-capital benchmark provided an important step in moving for-
ward the governance of company investment policy. That said, it was by no means easy
to shift company objectives toward rewarding investors and away from a focus on facili-
tating national employment and communication needs. Second, the company wa~ under
an important review by the British regulatory authority, the Office of Communications
(Ofcom). Deregulation of private postal services was still very much an experiment in
Britain. Due to recent competitive events in the country, Ofcom was reevaluating exist-
ing regulatory policies. The cost of capital provided an appropriate benchmark by which
to properly assess the profitability of Royal Mail's operations and the viability of Royal
Mail's operations under the existing regulatory policies.

Royal Mail pic

Royal Mail originated in 1516 when King Henry VIII established Sir Brian Tuke as
"Master of the Posts" with the charge to organize a postal service to carry mail between
British cities. Throughout its long history, Royal Mail proved to be the world's foremost

This public-sourced case was prepared Professor Michael J. Schill. Although all data used in the case is based
on public sources, some of the characters and situations in the case are fictitious. Copyright © 2017 by the
University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send
an e-mail tosales@dardenbusinesspublishing.com. No part ofthis publication may be reproduced, stored in a
retrieval system, used in a spreadsheet, or transmitted in any form or by any means--electronic, mechanical,
photocopying, recording, or otherwise-without the permission ofthe Darden School Foundation.

197
198 Part Three Estimating the Cost of Capital

pioneer in postal services. The company introduced many features that became ubiqui-
tous to postal services worldwide. In 1661, the Royal Mail postmaster, introduced the
first postmark with the declaration [in his own spelling], ''A stamp is invented that is
putt upon every letter shewing the day of the moneth that every letter comes to the of-
fice, so that no Letter Carryer may dare detayne a letter from post to post; which before
was usua1."} In the late 1700s, Royal Mail was the first postal service to operate a fleet
of independent mail coaches and outfit postal carriers in uniforms. In 1840, Royal Mail
was the first mail service to offer letter delivery services throughout the entire country
for a single rate. To certify postage prepayment in such a system, Royal Mail invented
the postage stamp. The original postage stamp, the Penny Wack, was a one-penny
stamp bearing the face of Queen Victoria (see Exhibit 13.1), and provided prepaid
postage for letters of up to half an ounce to be delivered anywhere in Great Britain and
Ireland. In recognition of Royal Mail's role in developing the first postage stamp, Brit-
ish stamps remained throughout the world as the only postage stamps that did not
specify the country of issuance on the stamp. In the mid-19th century, Royal Mail in-
troduced letter boxes where senders could simply deposit letters to be sent with the
affixed paid postage.
Now, due to the dramatic changes in postal services demand at the beginning of the
21st century, it was once again a time for innovation at Royal Mai1. In 2006, the British
government had removed Royal Mail's monopoly status, allowing private companies to
compete in collecting and sorting mail in the United Kingdom. With the change, gov-
ernment regulation was reduced, and Royal Mail was freed to set its own postage rates.
Over the next six years, Royal Mail responded by increasing the price of First-Class
postage from 32 pence to 60 pence.
In 2011 ,Parliament passed the important Postal Services Act. In this Act, the Postal
Services Commission was disbanded and the regulatory purview of postal services in
the United Kingdom shifted to the Ofcom. The intent was to dramatically alter the regu-
lation of Royal Mai1. Despite the increased liberties, however, the Act designated that
Royal Mail was required to maintain six-days-a-week, one-price-goes-anywhere uni-
versal service for letters regardless of the ownership structure of the company.
A decision to privatize the British mail service followed a government conclusion
that Royal Mail was less efficient and disciplined than many other post offices else-
where in Europe, and that it "urgently needed commercial confidence, capital, and cor-
porate experience to modernize quickly and effectively.,,2 This need followed a sustained
worldwide decline in letter volume in the first decade of the twenty-first century as a
result of the substitution of electronic co~munication. Vince Cable, the UK's Business
Secretary, had argued his position before the House of Commons: "The government's
decision on the sale is practical, it is logical, it is a commercial decision designed to put
Royal Mail's future in a long-term sustainable business.,,3 Over the years since deregu-
lation, the financial performance of Royal Mail improved and its operating margin was

IJohn G. Hendy, The History ofthe Early Postmarks ofthe British Islesfrom Their Introduction Down to
1840, (London: L. Upcott Gill, 1905),204.
2"The Privatisation of Royal Mail," National Audit Office, March 27,2014,5.
3Jennifer Rankin, "Royal Mail Privatization Will Not Affect Postal Delivery," The Guardian, July 10, 2013.
 Case 13 Royal Mail pIc: Cost of Capital 199

up fourfold. Cash flow for the company had grown from negative GBP504 million in
fiscal year 2009 to positive GBP282 million in fiscal year 2013.
The privatization of Royal Mail came in October 2013, when the British govern-
ment sold 60% of its 1 billion shares of Royal Mail to the public for 330 pence each. The
transaction generated proceeds of GBP2 billion. Of the shares sold, 73% were sold to
institutional investors and 23% were sold to 690,000 individual investors. 4
On Royal Mail's first day of trading on the London Stock Exchange, its share price
rose 38% to 455 pence. Despite high-profile strikes by postal workers who were strongly
opposed to the privatization, the share price for Royal Mail rose in the months following
the sale. By January 2014, the share price was trading at o.,ver 600 pence, a more than
80% increase over the sale price. Although the share price suffered a substantial price
reversal in mid-2014, over the fIrst six months of 2015 Royal Mail shares had recovered
and closed on July 20th at 511 pence. Exhibit 13.2 provides a history of returns to Royal
Mail equity investors relative to returns in the broad FTSE 100 Index since October
2013. Despite the strong and growing profits and assets, there was still substantial
uncertainty about the value of the shares.
Two sources of uncertainty were competition and regulation. In April 2012, the
Dutch postal service company TNT had entered the UK door-to-door postal services
market with a subsidiary business that would eventually become known as Whistl. Over
the ensuing years, the financial viability of the venture had proved challenging. Just last
month, Whistl management had announced that the company would be suspending its
door-to-door business to focus on its bulk mail processing service in Britain. It would
rely on Royal Mail's infrastructure for the "final mile" of delivery service. Two thou-
sand Whistl employees were laid off. The British government responded by calling into
question Ofcom's regulatory policies. In response, Ofcom began a high-profile review
of the postal services market in an effort to stimulate competition. One concern was that
Royal Mail maintained pricing power in the market such that it could engage in anti-
competitive pricing. Such allegations raised the question of what was the appropriate
level of profitability for a firm such as Royal Mail.
Moya Greene, CEO of Royal Mail, expressed the company's willingness to fully
comply with the review. She also indicated that Royal Mail was facing difficulties of its
own but was determined to continue to get better. She specifically stated:
This has been a challenging year. Through a continued focus on efficiency and tight cost
control, we have offset the impact of lower than anticipated UK parcel revenue this year,
so that operating profit before transformation costs is in line with our expectations. It has
also been a year of innovation, with a range of new initiatives delivered at pace. We have
introduced around 30 new projects, including services, products and promotions, to improve
our customer offering. 5

One example was the recent announcement that the company was pursuing an
efficiency objective by purchasing 76,000 hand-held scanner devices from Zebra

4National Audit Office, 43.

5 Royal Mail pIc Full Year Results 2014-15, Royal Mail plc,May 21, 2015.
200 Part Three Estimating the Cost of Capital

Technologies. Other initiatives included upstream investment opportunities such as

the acquisition of online shopping platforms such as Mallzee and Stor~Feeder.
Just that morning, Greene had issued an update on the company performance for
the most recent quarter and emphasized substantial success and concerns. She reported
that strong performance from the parcels business was offsetting declines in letter deliv-
ery revenue, and that the company was committed to investing in innovation and effi-
ciency.6She cautioned that the rest of year's performance would depend on the critically
important Christmas period. Exhibit 13.3 shows historical data on Royal Mail unit
volume. Exhibits 13.4 and 13.5 provide historical financial statements for Royal Mail.

The Cost of Capital

The cost of capital was theoretically defined as the prevailing return tha~ investors could
earn on alternative investments of similar risk. As such, it was inherently a figure deter-
mined by market forces rather than by the company. One attractive feature of the cost of
capital was that it provided an opportunity cost benchmark for evaluating investment
returns. Business returns that were expected to exceed the cost of capital were consid-
ered value creating to investors since the expected returns exceeded what investors
could generate on their own with investments of similar risk. Business returns that were
expected to be less than the cost of capital were considered value destroying to inves-
tors. Moreover, the cost of capital provided an estimate of the fair return for investors in
competitive businesses. It was expected that businesses in competitive markets would,
on average, earn their cost of capital.
In estimating the cost of capital it was common to consider all capital used in the
business. To estimate the opportunity cost of total business capital, it was common to
use a weighted average of the prevailing required return values for the various types of
investors in the business, such as debt holders and equity holders. This approach was
called the weighted average cost of capital (WACC).
In response to the burgeoning interest in a cost of capital estimate for Royal Mail,
Hart had asked a colleague, Kyle Brooks, to provide an estimate. Given the unique na-
ture of Royal Mail's business and its limited life in public capital markets, Hart recog-
nized that this was not an easy task. Still, Brooks had quickly generated an estimate of
3.828% and provided a stack of documentation. Exhibit 13.6 provides his analysis and
summary. Exhibits 13.7 through 13.9 provide his supporting documents.

6Royal Mail pIc press release, July 21, 2015.

 Case 13 Royal Mail pIc: Cost of Capital 201

EXHIBIT~ 13.1 The Penny Black, the World's First Postage Stamp (Issued in 1840)

Source: "Penny black," posted to public domain by the General Post Office of the United Kingdom of Great Britain
and Ireland, August 28, 2007, https://commons.wikimedia.org/wiki/File:Penny_black.jpg (accessed Jan. 3, 2017).

EXHIBIT 13.2 Cumulative Weekly Total Stock Returns-Royal Mail and FTSE 100 Index
35% . . - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ,

30%

25%

(I)
20%
...c::::J
i 15%
.~
...,
to 10%
:i
E
::::J
U 5%
,,-."".. ',.'",,''
\\
0%
FTSE100 Index
-5%

-10%
q-
~ ~ ~ ::t ::t ::t ::t ::t ::t ~ ::t ::t ::t ::t ~ ~ ~ ~ ~ ~C ~
LO
~
> u C iJ ~ c5. >. c
co ., .,
b 6.. t> > u Cco iJ ~ C. co ::J .,
0
u 0
Z 0 .,
co
Q)
u.. ~ « ~
Q)
'S::J
«
::J
0 z0 0 .,
Q)
(/)
Q) Q)
u.. ~ « ~
'S
.,
Source: Created by author using data from Investing.com.
202 Part Three Estimating the Cost of Capital

EXHIBIT 13.3 I Royal Mail Unit Volume History (Millions of Units, Period Ending
March 31)

Letters
Addressed letters 15,147 13,869 1~,342 13,009
Unaddressed letters 3,077 3,258 3,143 3,157
Total 18,224 17,127 16,485 16,166
Growth rate -6.0% -3.7% -1.9%

Parcels
Royal Mail core network 950 994 991 1,015
Parcelforce worldwide 66 70 77 86
Total
--
1,016
- -
1,064
--
1,068
- -
1,101
Growth rate 4.7% 0.4% 3.1%

Source: Company annual reports.

EXHIBIT 13.4 I Royal Mail Consolidated Income Statement

(Reported as of the End of March in
Millions of GBP)

Revenue 9,357 9,328

People costs 5,209 5,230
Distribution and conveyance costs 1,796 1,764
Infrastructure costs 1,047 1,019
Other operating costs 578 575
Transformation costs 241 145
-- --
Earnings before interest and tax 486 595

Finance costs 71 30
Finance income 4 4
Profit before tax 419 569

Tax 110 138

-- --
Profit for the period 309 431

Earnings per share 30.6 pence 42.8 pence

Source: Royal Mail 9;nnual report, 2015.

 Case 13 Royal Mail pIc: Cost of Capital 203

EXHIBIT 13.5 I Royal Mail Consolidated Balance Sheet

(Reported as of the End of March in
Millions of GBP)

Noncurrent assets
Property, plant, and equipment 1,989 1,933
Goodwill and intangible assets 392 482
Retirement benefit asset 1,723 3,179
Other noncurrent assets ~" ~
4,159 5,674

Current assets
Inventories 22 20
Trade and other receivables 926 949
Cash and current financial assets 369 348
1,317 1,317

Total assets 5,476 6,991

Current liabilities
Trade and other payables 1,652 1,668
Financial loans and borrowing 286 290
1,938 1,958

Noncurrent liabilities
Financial loans and borrowings 860 559
Deferred tax liabilities 151 474
Other liabilities 126 154
1,137 1,187

Total equity
Share capital 10 10
Retained earnings 2,332 3,843
Other equity ~ --=1
2,401 3,846

Source: Royal Mail annual report, 2015.

204 Part Three Estimating the Cost of Capital

EXHIBIT 13.6 Kyle Brooks's Cost-of-Capital Analysis

TO: Hillary Hart

FROM: Kyle Brooks
DATE: July 17, 2015
SUBJECT: RM's cost of capital

Based on the following assumptions, my estimate of Royal Mail's cost of capital is 3.828%.

Capital Structure
Since Royal Mail is funded with both debt and equity, I used the weighted average cost of capital (yVACC) method.
Based on the March 2015 balance sheet, current debt as a proportion of total capital makes up 6%, noncurrent
debt as a proportion of total capital makes up 12%, and equity accounts for 82%:

Capital Sources Book Values (in millions of GBP)

Current debt 290 6 % of total capital

Noncurrent debt 559 12% of total capital
Equity 3,846 82% of total capital

Cost of Debt
My estimate of Royal Mail's cost of debt was 3.188%, which is the weighted average between the 0.9% rate Royal
Mail is paying on its current debt and the 4.375% rate it is paying on its noncurrent debt. For the noncurrent debt
rate I used the coupon rate from a recent bond. On July 29, 2014, Royal Mail issued a 1O-year bond with an annual
coupon of 4.375%. The bond was rated by S&P at BBB. S&P recently reaffirmed that rating, and the bond is currently
trading at a price of 106.

I used a tax rate of 20%, which is the marginal tax rate for similar corporations in the United Kingdom, to estimate
the after-tax cost of debt.

Cost of Equity
I estimated the cost of equity at 4.11 % based on the prevailing dividend yield for Royal Mail. This was calculated
by dividing last year's dividend of 21 pence by the current share price of 511 pence. The dividend yield is a good
estimate of the cost of equity because it indicates exactly what equity holders received over the past year on
their investment.

I also looked at an estimate based on the capital-asset-pricing model (CAPM). My CAPM estimate of Royal Mail's
cost of equity was 5.321 %. To get this number, I used a risk-free rate of 1.551 %, the average yield on the 5-year
government bond over the past 18 months. Because of the short period since Royal Mail has been privatized,
there were few estimates of beta. But recently the equity research firm Chambers and Thompson published a beta
estimate for R9yal Mail of 0.65, so I used that. For my market risk premium I used 5.8%. This estimate comes from a
rigorous academic survey of British investors that was published a few months ago. However, for my estimate of
the cost of equity I selected the dividend yield estimate over the CAPM estimate because I felt it more prudent to
be conservative.

Weighted Average
Based on these assumptions, my estimate of Royal Mail's cost of capital was 3.828%.
WACC = Kd (1 - t) x D/(D + E) + Ke x E/(D + E)
= 3.188% x (1 - 20%) x 18% + 4.11 %x 82%

(continued)
 Case 13 Royal Mail pIc: Cost of Capital 205

EXHIBIT 13.8 I Kyle Brooks's Cost-of-Capital Analysis (continued)

Comparables Estimates
To confirm my estimate I calculated the weighted average cost of capital for five comparable publicly traded
companies. My estimates were:

National Grid: 3.853%

Severn Trent: 3.136%
Tesco: 5.475%
United Utilities: 3.281%
Vodafone: 5.660%

Since the comparable estimates are in the same general range as my 3.828% estimate for Royal Mail, I felt like my
estimate was a reasonable representation of the true cost of capital for Royal Mail.

Source: Created by author.

EXHIBIT 13.7 I One-Month Interbank Lending Rate and

Government Bond Yields (%)

1-Month Bond 5-Year Bond 10-Year Bond

Jan-14 0.47 1.78 2.71

Feb-14 0.47 1.80 2.72
Mar-14 0.47 1.87 2.74
Apr-14 0.47 1.86 2.67
May-14 0.48 1.80 2.57
Jun-14 0.48 1.99 2.67
Jul-14 0.47 1.98 0.62
Aug-14 0.47 1.70 2.37
Sep-14 0.47 1.78 2.43
Oct-14 0.47 1.56 2.25
Nov-14 0.47 1.30 1.93
Dec-14 0.47 1.20 1.76
Jan-15 0.48 0.91 1.34
Feb-15 0.48 1.28 1.79
Mar-15 0.48 1.09 1.58
Apr-15 0.48 1.30 1.84
May-15 0.48 1.26 1.80
Jun-15 0.51 1.46 2.03

Data source: Bank of England Statistical Interactive Database, http://www.

bankofengland.co.uk/boeapps/iadb/lndex.asp?first=yes&SectionRequired=I&Hi
deNums=-1 &Extralnfo=true&Travel=Nix.
206 Part Three Estimating the Cost of Capital

EXHIBIT 13.8 I UK Corporate Benchmark Bond

Yields for 10-Year Maturity in
GBP (July 14, 2015)

AAA 2.503
AA 2.839
A 3.356
BBB 3.776
BB 4.773
B 5.883

Sources:·Thomson Reuters and author estimates.

EXHIBIT 13.9 I Financial Data for Comparables (Market Data as of July 14, 2015, Other Data
is Most Recent Available)

Company Industry

National Grid Electricity and gas utility

Severn Trent Water utility
Tesco Food retailer
United Utilities Water utility
Vodafone Telecom munications

National Grid Severn Trent Tesco United Utilities Vodafone

Price per share (pence) 855 2,190 200 900 230

Dividend per share (pence) 42 80 15 36 16
Shares outstanding (millions) 3,730 239 8,096 682 26,440
Market capitalization (millions) 31,892 5,234 16,192 6,138 60,812
Book equity (millions) 11,911 1,078 14,715 2,216 70:802
Book debt (millions) 25,950 4,622 11,213 6,042 25,362
Beta 0.60 0.79 0.87 0.67 0.86
Credit rating BBB- BBB+ BB+ BBB+ BBB+

Data source: Financial Times, https://markets.ft.com/data/equities.