ASSIGNMENT BRIEF: THE COST OF CAPITAL

This is an analysis in ‘retrospect’. You have the opportunity to see how the cost of capital
analysis works in practice by using real past data to move forward from an analyst’s point of
view.
It is mid-2001 (June) and you are a senior analyst working for Grosse-Point Blank Group (GPB
henceforth), a mutual fund management firm that invests in large capitalisation, S&P firms
only. The group has invested heavily on value stocks (i.e. Citicorp, JP Morgan) and what one
also considers old-economy stocks (i.e. Exxon-Mobil, General Motors etc.). Despite the stock
market declining over the past 18 months, GPB has performed extremely well; for the year
2000 the total return of the fund was 15.5% as the S&P fell by 5.3%. Currently, the fund’s
year-to-date returns are 7.6% even when the S&P’s returns are a miniscule 0.3%. Mrs. Janet
Sims, an experienced portfolio manager ponders over the American Apparel (AA henceforth)
company as a potential stock investment she considers to be a promising stock. AA
manufactures and sells apparel equipment ranging from glasses, sunglasses, sports shoes,
tracksuits, trousers, jackets, hoodies etc. AA’s hare price had dropped dramatically since the
beginning of the year though.
Just a few weeks earlier, AA had its annual analysts’ meeting in order to disclose its final year
results for 2000-2001. Yet the meeting had a dual purpose; the company knew obviously
about the declining share price and they wanted to also communicate their forward looking
strategy for revitalising the company in the wake of disappointing results. These results for
example can be depicted as follows: since 1997 their revenues had plateaued at around $8.5-
$9 billion and net income had fallen by more than $200million (exhibit 1). The company’s
market share had fallen from 39% in 1997 to less than 31% in 2001. At the meeting,
management revealed plans to address both top-line growth and operating performance. To
boost revenue, the company would develop more apparel products in the mid-priced
segment; a segment that AA had overlooked in recent years. Cost-wise the company intended
to tightly control expenses. In the same meeting, AA company executives voiced their
expectations of long-term revenue growth in the region of 8-10% yearly and earnings growth
of above 15%.
Analyst’s reactions to the management estimates of growth above where mixed: some
analysts thought such estimates were too optimistic and aggressive, trying to mask the
company’s problems and paint a more positive picture of the company given the recent
disappointing performance for a number of years. Others disagreed, claiming that AA had
indeed significant growth potential in the apparel business especially in the international
market. Mrs. Janet Sims, read all these reports and the analysts reaction but still could not
decide on what course of action to take. A report from the Bank of America trading desk
suggested a strong ‘buy’, while a report from Merrill Lynch suggested a simple ‘hold’ and at
the same time the UBS/Wachovia firm suggested ‘sell’. Your line manager, decided to ‘go it
alone’ and develop her own cash flow analysis and forecast. Mrs. Sims analysis showed that
at a current price of £42.09 per share the company was overvalued at a cost of capital of 12%.
Mrs Sims went further on to conduct a sensitivity analysis. Her analysis actually showed her
that at a cost of capital of 11.17% the company was actually undervalued. (See exhibit 2 for
all analysis).
It all was very confusing as in two days’ time she had to go to a major portfolio managers’
meeting along with the major shareholders to present her findings. Mrs. Sims enlisted a junior
analyst’s help, Ms. Jenna Franklin in order to assist with the calculations of the cost of capital.
Ms. Franklin was a very young and talented individual, straight out of university employee
and as such this was a first major test for Ms. Franklin. She quickly gathered all data she
thought she required necessary for her analysis (see exhibits 1 through to 4). She quickly
moved on with her analysis and spent the whole day estimating the cost of capital at the end
of which she submitted her analysis via a memo mail to Mrs. Sims explaining all calculations,
workings and assumptions fed into the models (exhibit 5).
Mrs. Sims received Ms. Franklin’s analysis but as an experienced manager she decided to risk-
manage this by verifying such an analysis. She has asked you, a more senior analyst and a
mentor to Ms. Franklin, to review this from end-to-end and identify and address any financial
analysis problems. As a mentor to Ms. Franklin and as a senior analyst you have a vested
interest in solving this effectively. You are asked to evaluate the following:

1. Why is it important to estimate a firm’s cost of capital? What does it represent? Is the
WACC set by investors or by managers?
2. Do you agree with Ms. Franklin’s calculations? If yes, then justify why. If not, then what
is your estimate of the WACC? Are there any errors made in Ms. Franklin’s analysis (if any)?
Show all your workings and justify your assumptions.
3. Which method is better suited for calculating the cost of equity in this case? What are
the advantages and disadvantages of each method?
4. What do you believe to be the optimal capital structure of the company in your view
and why? How is the trade-off theory related to this?
5. Would you recommend Mrs. Sims proposes an investment in AA? Justify your answer.
EXHIBIT 1. CONSOLIDATED INCOME STATEMENTS

Exhibit 1. Consolidated Income Statements

Year ended April 30 (in millions of $s except on a per share basis data
1995 1996 1997 1998 1999 2000 2001
Revenues 4,760.8 6,470.6 9,186.5 9,553.1 8,776.9 8,995.1 9,488.8
CoGS 2,865.3 3,906.7 5,503.0 6,065.5 5,493.5 5,403.8 5,784.9
Gross Profit 1,895.5 2,563.9 3,683.5 3,487.6 3,283.4 3,591.3 3,703.9
Sell. & Admin Expenses 1,209.8 1,588.6 2,303.7 2,623.8 2,426.6 2,606.4 2,689.7
Operating Income 685.7 975.3 1,379.8 863.8 856.8 984.9 1,014.2
Interest Expense 24.2 39.5 52.3 60.0 44.1 45.0 58.7
Other Expense 11.7 36.7 32.3 20.9 21.5 23.2 34.1
Restructuring Charge 0.0 0.0 0.0 129.9 45.1 -2.5 0.0
Income before Taxes 649.8 899.1 1,295.2 653.0 746.1 919.2 921.4
Income tax 250.2 345.9 499.4 253.4 294.7 340.1 331.7
Net Income 399.6 553.2 795.8 399.6 451.4 579.1 589.7

Diluted EPS 1.36 1.88 2.68 1.35 1.57 2.07 2.16

Av.Shares outstanding (diluted) 294.0 293.6 297.0 296.0 287.5 279.8 273.3

Growth %
Revenue 0.359 0.420 0.040 -0.081 0.025 0.055
Operating Income 0.422 0.415 -0.374 -0.008 0.150 0.030
Net Income 0.384 0.439 -0.498 0.130 0.283 0.018

Margins %
Gross Margin 0.396 0.401 0.365 0.374 0.399 0.390
Operating Margin 0.151 0.150 0.090 0.098 0.109 0.107
Net Margin 0.085 0.087 0.042 0.051 0.064 0.062

Effective Tax Rate* 38.5 38.6 38.8 39.5 37.0 36.0

* US statutory tax rate was 35%. The satte tax varied from 2.5% to 3.5%
Source: SEC filings & UBS Warburg
EXHIBIT 2. DISCOUNTED CASH FLOW ANALYSIS
Exhibit 2. Discounted Cash Flow Analysis
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Assumptions
Revenue Growth % 7.0 6.5 6.5 6.5 6.0 6.0 6.0 6.0 6.0 6.0
CoGS/Sales % 60.0 60.0 59.5 59.5 59.0 59.0 58.5 58.5 58.0 58.0
S&A / Sales % 28.0 27.5 27.0 26.5 26.0 25.5 25.0 25.0 25.0 25.0
Tax Rate % 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0
C.Assets / sales % 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0
C. Liabilities / sales % 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5

Cost of Capital = 12%

Terminal Val. Gr. at g = 3%

Discounted Cash Flow

(in millions of $s except on
a per share basis data)
OPERATING INCOME 1,218.4 1,351.6 1,554.6 1,717.0 1,950.0 2,135.9 2,410.2 2,554.8 2,790.12,957.5
TAXES 463.0 513.6 590.8 652.5 741.0 811.7 915.9 970.8 1,060.21,123.9
NOPAT 755.4 838.0 963.8 1,064.5 1,209.0 1,324.2 1,494.3 1,584.0 1,729.91,833.6
CAPEX 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Change in W.C -8.8 174.9 186.3 198.4 195.0 206.7 219.1 232.3 246.2 261.0
Free Cash Flow 764.2 663.1 777.5 866.1 1,014.0 1,117.5 1,275.2 1,351.7 1,483.71,572.6
Terminal Value 17,473.3
TOTAL FLOWS 764.2 663.1 777.5 866.1 1,014.0 1,117.5 1,275.2 1,351.7 1,483.7 19,045.9
Present Value Cash Flows 682.3 528.6 553.4 550.4 575.4 566.2 576.8 545.9 535.0 6,132.3

Enterprise Value 11,246.4

Less: Current Total Debt 1,296.6
Equity Value 9,949.8
Current Shares Outstanding 271.5
Share Price 36.65
Current Share Price 42.09

SENSITIVITY ANALYSIS
Discount Rate
Equity Value in $
8% 76
8.5% 68
9% 61
9.5% 56
10% 51
10.5% 47
11% 43
11.17% 42.09
11.5% 40
12% 36.65
EXHIBIT 3. CONSOLIDATED BALNACE SHEETS
Exhibit 3. Consolidated Balance Sheets
April 30 April 30
in millions of $s 2000 2001
Assets
Current Assets:
Cash and Equivalents 254.30 304.00
Accounts Receivable 1,569.40 1,621.40
Inventories 1,446.00 1,424.10
Deferred income Taxes 111.50 113.30
Prepayments 215.20 162.50
TOTAL CURRENT ASSETS 3,596.40 3,625.30
PPE 1,583.40 1,618.80
GOODWILL 410.90 397.30
OTHER ASSETS 266.20 178.20
TOTAL ASSETS 5,856.90 5,819.60

LIABILITIES & EQUITY

Current Liabilities:
Current long term debt 50.10 5.40
Notes payable 924.20 855.30
Accounts Payable 543.80 432.00
Accruals 621.90 472.10
Income tax due 0.00 21.90
TOTAL CURRENT LIABIL. 2,140.00 1,786.70
Long term Debt 470.30 435.90
Other Liabilities 110.30 102.20
Redeemable Stock/Debt 0.30 0.30
SHAREHOLDERS' EQUITY:
Common Stock 2.80 2.80
Capital in Excess 369.00 459.40
Stock compensation -11.70 -9.90
Other Income -111.10 -152.10
Retained Earnings 2,887.00 3,194.30
Total Equity 3,136.00 3,494.50
Total Liabilities & Equity 5,856.90 5,819.60
EXHIBIT 4. CAPITAL MARKET DATA FOR 2001

Exhibit 4. Capital Market and Financial Data July 2001

Current Yields on US Treasuries Historical US Equity Premiums

3-month 3.59% 1926 - 2000
6-month 3.59% Geometric Mean 5.90%
1 year 3.59% Arithmentic Mean 7.50%
5 year 4.88%
10 year 5.39% AAs Historic Betas
20 year 5.74% 1996 0.98
1997 0.84
Current Yield on Adipas Debt 1998 0.84
Coupon (Semi-annual) 6.75% 1999 0.63
Issued 7/15/96 2000 0.83
Maturity 7/15/21 YTD (2001) 0.69
Current Price $95.60 Average 0.8

Consensus EPS Estimates

FY2002 $2.32
FY2003 $2.67

Dividend History Payment Dates and Forecasts

Year Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
1997 0.10 0.10 0.10 0.10 0.40
1998 0.12 0.12 0.12 0.12 0.48
1999 0.12 0.12 0.12 0.12 0.48
2000 0.12 0.12 0.12 0.12 0.48
2001 0.12 0.12 0.12 0.12 0.48

Value Line Dividend Growth Forecast from 1998-2000 to 2004-2006: 5.50%

EXHIBIT 5. MEMO TO MRS. SIMS

Exhibit 5. Memo

From: Ms. Jenna Franklin

To: Mrs. Janet Sims
Date: 15th May 2001
Subject: AA Cost of Capital

My estimate for the company's cost of capital come around 8.4%-8.5 %

based on my methodology and assumptions and calculations below:

Methodology:
WACC method used since firm is financed both by Debt and Equity

DEBT: (millions $s) EQUITY

Current Portion of Debt 5.4
Notes Payable 855.3
Long-term Debt 435.9
Total Debt 1296.6 3494.5
Total Finance 4791.1
% of Finance 0.271 0.729

Cost of Debt:
My estimate for AA's cost of debt is 2.7%. That is:
Interest Expense for the year 2001 divided by average debt
This rate is lower than treasury because the firm raised debt in YEN notes between 2.0% and 4.3%
I adjusted for tax (after tax cost of debt) using a 38% average tax rate

Cost of Equity:
My estimate for AA's cost of equity is 10.5%. That is:
I utilised the CAPM only (I did not use the DDM or the Earnings Capitalisation Rate)
Based on the CAPM I got: Ra = rf + b(Rm-Rf) = 5.74 + 0.80*5.90 = 10.46%

WACC:
My estimate for the firm's WACC is 8.4%. That is:
WACC = D/V * Rd(1-t) + E/V * Re = 0.27 * 2.70 + 0.73 * 10.50 = 8.4%