# 1. Calculate the cost of equity using the Capital Asset Pricing Model

Information from McCormick Your task is to make an estimate of McCormick & Company’s Weighted Average Cost of Capital (WACC) to us The CFO plans to borrow a portion of the required $350 million initial investment for this project using 20 yeara study of the company’s WACC in early 2010. Interest rates have risen since the last study when the McCormweights between debt and equity in the overall capital structure since 2010. The most significant change was the acquisition of RB Foods. It is the main reason for this study. Here is what On August 17, 2017, we completed the acquisition of Reckitt Benckiser’s Food Division (“RB Foods”) from Reckittacquisition was funded through our issuance of approximately 6.35 million shares of common stock non-votingnotes and pre-payable term loans (see note 6 of the financial statements). The acquired market-leading brandsour robust global branded flavor portfolio. We believe that these additions move us to a leading position in theconsumer and industrial segments.The RB Foods acquisition resulted in acquisitions contributing more than one-third of our sales growth in 2017 As part of your work, you will be asked for a recommendation for the cost of equity. There are three widely acthe Discounted Cash Flow approach (DCF) and the debt rate plus a risk premium of 3% to 5% recommended bymethods. Your recommendation for the cost of equity will be necessary so you can undertake the calculation Questions:1. You have been asked to calculate the cost of equity using the Capital Asset Pricing Model (CAPM). The CFOarguing that Investors should make long term investments; that rate is 3% today. The expected return on the sthat you use an expected return of 9% for the average stock. The market risk Premium (RP M) will be 6%. 9% m Calculate the cost of equity (Rs) using the CAPM. The formula is Rs = rRF + (RPM ) x β. Rs is the required retuexcess of the risk free rate, and β , (Beta) is the stocks relative risk. β is also described as the estimate of the a 2. The Discounted Cash Flow model is referred to as the Direct Dividend Model in the MBA 620 course materiaEquity, D1 is the expected future dividend, P0 is the price of the stock today and g is the expected growth in divFor this calculation, please use the March 17, 2020 closing price of $138.70 per share. Calculate the cost of e 3. Cristina Flores is an advisor to a board member who works at a private equity firm. She has told the CFO thamust logically be higher than the company’s debt rate. The estimate is that 3% to 5% should be added to the cMake your own estimate of the relative risk of McCormick & Company. Then, calculate the cost of equity (Rs) 4. Calculate the Weighted Average Cost of Capital (WACC) for McCormick and Company using the formula WANote that -Rs = the cost of equityRd = the cost of debtT = the tax rateWD = Value of debt / (Value of debt plus value of equity)WS = Value of equity / (Value of debt plus value of equity) **Note that the weight of debt plus the weight ofIn order to estimate the weights of debt and equity in the total capital structure, the CFO suggests using the bothe year end November 2019 McCormick 10-K. Look on the Balance sheet and add the following — Short termequity, use the following data: On March 17, 2020 the market value of equity (or “Market Cap”) for McCormictax rate – an estimate of the combination of federal and state income tax rates. Make your own best estimate Answer Questions Below:#1Risk Free Rate Market Premium Beta Premium Cost of Equity #2D1P0D1 / P0gDCF Cost of Equity#3Bond Rate #4Calculate weightsShort-term borrowingsCurrent portion of long-term debtLong-term debtTotal DebtWeightsDebt Interest rateTax RateAfter tax cost of debtDebt term rage Cost of Capital (WACC) to use as the discount rate for evaluating capital projects, such as the one in the next tab. ment for this project using 20 year bonds. For most of the past 10 years, the company has used 7% as the discount rate. This was basedthe last study when the McCormick & Co rate average interest rate was 3%. We will use 4% today. Also, there has been a change in th eason for this study. Here is what our MD&A reported about that acquisition. Division (“RB Foods”) from Reckitt Benckiser Group plc. The purchase price was approximately $4.2 billion, net of acquired cash. Theares of common stock non-voting (see note 13 of the financial statements) and through new borrowings comprised of senior unsecurede acquired market-leading brands of RB Foods include French’s®, Frank’s Red Hot® and Cattlemen’s®, which are a natural strategic fit wiove us to a leading position in the attractive U.S. condiments category and provide significant international growth opportunities for our third of our sales growth in 2017 and is expected to result in acquisitions contributing more than one-third of our sales growth in 2018. equity. There are three widely accepted methods used to calculate the cost of equity. They are the Capital Asset Pricing Model (CAPMum of 3% to 5% recommended by one board member. This last is often used by very wealthy investors as a check on the other twoou can undertake the calculation estimating the WACC. Pricing Model (CAPM). The CFO estimates the Beta as 0.90. Management wants to use the 30 year bond rate as the risk free rate,day. The expected return on the stock market as a whole has been estimated to be 7%, 10% and 12% by various studies. The CFO asksPremium (RP M) will be 6%. 9% minus 3% = 6%. (RPM ) x β. Rs is the required return on equity or the Cost of Equity, r RF is the risk free rate, RP M is the required stock market return indescribed as the estimate of the amount of risk that an individual stock contributes to a well balance portfolio. el in the MBA 620 course materials. The formula reduces to Rs = (D 1 / P0 ) + g where Rs is the required return on equity or the Cost ofnd g is the expected growth in dividends. The CFO notes that the expected future dividend is $2.38 and the expected growth rate is 7%er share. Calculate the cost of equity (Rs) using the DCF approach. ity firm. She has told the CFO that sophisticated investors use a quick estimate of the cost of equity. She says that the cost of equity% to 5% should be added to the company’s long term interest rates. McCormick & Company estimates its current borrowing cost at 4%, calculate the cost of equity (Rs) using this “own debt plus 3% to 5%” formula. d Company using the formula WACC = (W D x RD x (1-T)) + (WS x Rs) weight of debt plus the weight of equity must total to 100%, as there are only two components in the capital structure.**ure, the CFO suggests using the book value of debt and the market value of equity. To determine the book value of debt, use data fromnd add the following — Short term borrowings, Current portion of long term debt, and Long term debt. To determine the market value oy (or “Market Cap”) for McCormick (MKC ) – as found on Yahoo finance – was $18.42 billion. Use 4% for the cost of debt. Use 27.5% as ts. Make your own best estimate of the cost of equity based on your work in questions 1, 2, and 3. Beta x Market PremiumRisk Free rateCAPM cost of Equity Market Cap Equity Total Capital Cost of equityEquity term WACC next tab. nt rate. This was based onhas been a change in the of acquired cash. Thesed of senior unsecureda natural strategic fit withwth opportunities for our ur sales growth in 2018. et Pricing Model (CAPM),ck on the other two as the risk free rate,s studies. The CFO asks stock market return in n equity or the Cost ofected growth rate is 7%. hat the cost of equitynt borrowing cost at 4%. ructure.**e of debt, use data frommine the market value ofof debt. Use 27.5% as the

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