Wacc assignment-final version 240517 PDF

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WACC REPORT ON NESTLE BX2014: FINANCIAL MANAGEMENT NAME: S. SRIRAM STUDENT ID:1329 2687 LECTURER & TUTOR: DR TY THONG SUBMISSION DATE: 26/05/17

Table of contents: 1. History of Nestle…………………………………………………………………………………………...1 2. What is WACC?...........................................................................................................................................1 3. Total market value of equity ……………………………………………………………………………....1 4. Total market value of debt………………………………………………………………………………....2 5. Total market value………………………………………………………………………………………....2 6. Cost of equity……………………………………………………………………………………………....2 7. Cost of debt………………………………………………………………………………………………...3 8. Gearing ratio analysis……………………………………………………………………………………...3 9. Recommendation…………………………………………………………………………………………..4 10. References………………………………………………………………………………………………..5 11. Appendices……………………………………………………………………………………………….6

1. History of Nestle Nestle was initially started as two separate companies: Anglo-Swiss Condensed Milk Company which was started by Charles and George Page in 1866 and Farine Lactee founded by Henri Nestle in 1867. As they expanded, they got engaged in intense competition by selling their own versions of condensed milk and infant cereal. In 1905, the two companies merged together to form the Nestle and Anglo-Swiss company, which retained its name until 1947 when it took over Alimentana, which manufactured Maggi products. In 1977, Nestle Alimentana was renamed Nestle S.A. and over the years, it took over the control of Kit Kat, Smarties, and Aero chocolate brands from Rowntree Mackintosh. Nestle S.A. entered the water business by acquiring San Pellegrino in 1988 and Perrier in 1992. Also, the Swiss multinational expanded its ice cream business by taking over Movenpick and Dreyer’s in 2003 and acquiring the rights over Haagen Dazs ice cream in USA and Canada. Today, Nestle is one of the world’s most admired and profitable companies with a ranking of 66 on the Fortune Global 500 2016 list. It employs 335,000 people and sells its products in 196 countries (The Nestle company history, 2017). 2. What is WACC? WACC (Weighted Average Cost of Capital) is the average cost that a company has to pay for the debt and equity capital that it borrows. The formula is calculated by multiplying the cost of two capital sources (debt and equity) by their relevant weights, and then adding the products together to figure out the overall WACC value. (Etzel,2003). WACC formula: WACC= (E/V) * RE + (D/V) * (Rd)*(1-Tc) in which E: Total market value of the company’s equity D: Total market value of the company’s debt V: Total market value of the company (E+D) RE: Cost of equity RD: Cost of debt Tc: Corporate tax rate Nestle’s total equity: 65,981 million Swiss francs Nestle’s total debt: Commercial paper + Bonds + Other financial debt = 7,180 million + 13,308 million + 3,776 million = 24,264 million Swiss francs Nestle’s total market value: Total equity + Total debt = 65,981 million + 24,264 million= 90,245 million Swiss francs Nestle’s cost of equity = Rf +β (Rm-Rf) = -0.20 +0.77 (6.09- (-0.20)) = -0.20 + 0.77 (6.09+0.20) = -0.20 + 0.77(6.29) = -0.20 + 4.8433 = 4.6433% Nestle’s cost of debt = (Interest expense/ Total debt) = (543/24264) = 2.23% Corporate tax rate in Switzerland: 17.92% The WACC for Nestle is: (65981/90245) *4.6433 + (24264/90245) *2.23*(1-0.1792) = (65981/90245) *4.6433+ (24264/90245) *2.23*0.8208 = 3.394+ 0.492 = 3.886% 3. Total market value of equity (E) Market value of equity is the total value of all the company’s outstanding shares or stock measured by their market prices. It is also the total value of all the outstanding stock in the stock market as measured at a point in time (Chatham, 2015). According to Nestle’s balance sheet (2016), the total equity is 65,981 million Swiss 1

francs. This has been calculated by adding up the total equity that is to be given to the parent company’s shareholders consisting of elements such as share capital, treasury shares, translation reserve, other reserves and retained earnings along with non-controlling interests. 4. Total market value of debt (D) Total market value of debt is calculated by adding up the company’s contract amount consisting of commercial paper, bonds, and other financial debt. A commercial paper is an unsecure, short term debt issued by a company to finance its accounts receivable, inventories and other short term liabilities (Investopedia, 2017). A bond refers to a security that is issued by a government or a public company to raise capital (MacMillan,2003). Bonds are of two types- short term and long term. Short term bonds are those which can be redeemed in 2 years or less while long term bonds which mature in 7 years or even more until its redemption date (QFinance, 2014). According to Nestle’s balance sheet (2016), its total financial debt amounts to 24,264 million Swiss francs. This is because Nestle’s total market value of debt can be calculated by adding up both the short term and long term debt liabilities and is as follows: Total debt = Commercial paper + Bonds + Other financial debt = 7,180 million + 13,308 million + 3,776 million = 24,264 million Swiss francs 5. Total market value (V) Total market value, also known as total capital, is calculated by adding up the total debt (both short-term and long-term) and total equity. Nestle’s total capital borrowed is as follows: Total debt + Total equity = 24,264 million + 65,981 million = 90,245 million Swiss francs 6. Cost of Equity (RE) The cost of equity is the return that shareholders require for investing in the shares of a particular company. There are two methods of calculating cost of equity: 1) Dividend growth model: This model is used only when companies are paying current dividends at a reasonably constant rate. The formula for this model is as follows: RE= (D1/P0) + g in which RE= Cost of equity D1= Expected dividend in a single period P0 = Current share price g = dividend growth rate 2) CAPM (Capital Asset Pricing Model): This model is useful for all companies provided the beta value is available and can adjust well to systematic risks. The formula for this model is shown below: RE= RF + βE (E(RM) – RF) in which RE= Cost of equity RF= Risk-free rate βE= Beta i.e. asset’s exposure to systematic risk E(RM) – RF= Market risk premium (Investopedia, 2017). Since there is no sign that Nestle has been paying constant dividends over time, we use the CAPM model, also known as the SML (Security Market Line) model. To calculate this, the following values were obtained: Risk-free rate (RF) = -0.20 Beta value (βE) = 0.77 Market free rate (E(RM)) = 6.09 Market risk premium = E(RM) – Rf = 6.09- (-0.20)= 6.09 + 0.20 = 6.29 Therefore, the cost of equity for Nestle is: 2

RE= RF + βE (E(Rm) – RF) = -0.20 + 0.77(6.29) = -0.20 + 4.8433 = 4.6433% The cost of equity of 4.6433% means that stockholders require a return on investment of approximately 4.6433% i.e. for every franc they invest in Nestle, they require a return of 4.6433 cents. 7. Cost of Debt (RD) The cost of debt is the effective rate that a company pays on its current debt liabilities. To calculate the organization’s cost of debt, it needs to figure out the total amount of interest it is paying on each of its short-term and long-term debts for the year. The formula for calculating cost of debt is as follows: (Interest expense/Total debt) (Investopedia, 2017). Nestle’s cost of debt = (543/24264) = 2.23% The cost of debt of 2.23% means that for every dollar investors lend to Nestle, they require a return of 2.23 cents. According to Karen Rogers (2017), this value is lower than that of cost of equity due to the following reasons: (i) Ownership protection: Issuing bonds does not change one’s ownership percentage in the corporation unlike selling stock shares which dilutes one’s ownership percentage. This is because the stockholders could band together and outvote on corporate matters unlike bondholders who request investors to loan the company money. (ii) Fixed maturity date: Bonds have a finite life span. This means that they have a maturity date for paying the periodical interest and repaying the original loan. On the other hand, a company must offer a substantial premium to investors to convince them to sell back its shares which are kept forever when stock is issued to these shareholders. (iii) Interest and tax deduction: The interest expense on bonds is tax deductible and as a result, a company can reduce its taxable income by issuing bonds. On the other hand, dividends paid to stockholders are not tax deductible. If the company can issue bonds at a low interest rate, then the interest deduction can make the debt costs quite low. (iv) Callable feature: Callability means redeeming bonds earlier than the actual maturity date. When interest rates fall, old bonds with an earlier interest rate are called in so that the company can sell new bonds at a lower interest rate. The called bonds are paid off based on their face value and the interest rates stop accumulating as of the callable date. On the other hand, a company is entitled to paying dividends to its shareholders indefinitely after selling shares. If it defaults on its payments, the shareholders can file a lawsuit against the corporation. 8. Gearing ratio analysis Gearing ratio is a type of ratio that measures how a firm’s day to day operations are funded by a mix of owner’s funds i.e. equity and borrower’s funds i.e. debt. Companies with higher gearing ratios are more likely to be affected by economic downturns. This is because companies with higher leverage have higher amounts of debt as compared to equity. However, companies with high gearing ratios do not necessarily signify that they are in poor financial conditions; rather, they have a riskier financial structure than those with low gearing ratios (Investopedia, 2017). The gearing ratios of Nestle S.A. are as follows: Leverage ratio = Total debt/ Total equity = 24264/65981= 0.367 Debt ratio = Total debt/Total assets = 24264/131901 = 0.184 Equity ratio = Total equity/ Total assets = 65981/131901= 0.50023 According to the above-mentioned figures, the leverage ratio is 0.367. This means that for every $1 of shareholder’s equity, Nestle has 0.367 cents in debt. Normally, a debt to equity ratio which is greater than 2.0 indicates a risky scenario for investors because this may result in volatile earnings due to additional interest expenses that arise from issuing debt and if it is high, then it may result in bankruptcy. However, Nestle’s equity value is much greater than its debt which suggests that its leverage ratio is not very risky and that its capital 3

structure is contributing to higher rates of return, thereby increasing the Swiss multinational’s profitability (Investopedia, 2017). Debt ratio is the ratio that reflects what is the total value of assets that a company must sell to pay its total debt. (My Accounting ratio, 2017). The overall debt ratio is 0.184 which means that while Nestle has relied on a lot of debt, its assets is 5.43 times its total debt value. This denotes that while the debt ratio is relatively stable, the company needs to cut back on its debt financing to avoid higher chances of defaulting on its payments. Equity ratio is the ratio that denote what is the total value of assets that have been financed by equity (My Accounting ratio, 2017). The overall equity ratio is 0.50023 which means that a large proportion of Nestle’s assets have been financed through issuing shares. This suggests that Nestle is likely to meet less interest payments on its loans and that it has sufficient cash for future product expansions and growth opportunities. 9. Recommendation The current WACC rate for Nestle is 3.886% with a gearing ratio of 0.367. For the top management of Nestle to maximise shareholder’s wealth, it is recommended that they maximise the WACC rate by lowering the debt finance and increasing the equity finance equally by 20,000 million Swiss francs. This is because Nestle’s amount of debt is on the rise and if it is not kept under control, then the company risks defaulting on its payments. By doing so, the new WACC rate would be as follows: Nestle’s new total equity: 65,981 million + 20,000 million = 85,981 million Nestle’s new total debt: 24,264 million – 20,000 million = 4,264 million Nestle’s new total market value: New total equity + New total debt = 85,981 million + 4,264 million= 90,245 million Swiss francs Nestle’s new cost of equity = Rf +β (Rm-Rf) = -0.20 + 0.77(6.29) = -0.20 + 4.8433 = 4.6433% Nestle’s new cost of debt = (Interest expense/ Total debt) = (543/4264) = 12.73% Corporate tax rate in Switzerland: 17.92% The WACC for Nestle is: (85981/90245) *4.6433+(4264/90245) *12.73*(1-0.1792) = (85981/90245) *4.6433+(4264/90245) *12.73*0.8208 = 4.424+ 0.494= 4.918% With the changes in total equity and total debt values, the new WACC rate is 4.918%, higher than the previous rate of 3.886%. This would be good for Nestle as it represents a slightly higher cost of financing its new product developments and growth operations while lowering debt financing and increasing equity financing.

10. References: 4

bond (finance). (2003). In The MacMillan encyclopedia (2nd ed.). Aylesbury, UK: Market House Books Ltd. Retrieved from https://elibrary.jcu.edu.au/login? url=http://search.credoreference.com/content/entry/move/bond_finance/0?institutionId=429 Consolidated financial statements of the Nestle group. (2016). Retrieved from http://www.nestle.com/asset-library/documents/library/documents/financial_statements/2016-financialstatements-en.pdf Cost of debt. (2017). Retrieved from http://www.investopedia.com/terms/c/costofdebt.asp Cost of equity (2017). Retrieved from http://www.investopedia.com/walkthrough/corporatefinance/5/cost-capital/cost-equity.aspx Debt ratio. (2017). Retrieved from http://www.myaccountingcourse.com/financial-ratios/debt-ratio Equity ratio. (2017). Retrieved from http://www.myaccountingcourse.com/financial-ratios/equity-ratio Gearing ratio. (2017). Retrieved from http://www.investopedia.com/terms/g/gearingratio.asp Investing answers. (2017). Retrieved from http://www.investinganswers.com/financialdictionary/financial-statement-analysis/weighted-average-cost-capital-wacc-2905

Investopedia stock analysis: Explaining market value of equity (2015). . Chatham: Newstex. Retrieved from https://search-proquest-com.elibrary.jcu.edu.au/docview/1667129493?accountid=16285 Karen Rogers. (2017). Why corporations issue bonds rather than stocks. Retrieved from http://smallbusiness.chron.com/corporations-issue-bonds-rather-stocks-75530.html Leverage ratio. (2017). Retrieved from http://www.investopedia.com/terms/l/leverageratio.asp

long-term bond. (2014). In Qatar Financial Center, & Qatar Financial Center (Eds.), QFinance: the ultimate resource (5th ed.). London, UK: A&C Black. Retrieved from https://elibrary.jcu.edu.au/login? url=http://search.credoreference.com/content/entry/qfinance/long_term_bond/0?institutionId=429 Nestle SA. (2017). Retrieved from http://in.reuters.com/finance/stocks/overview?symbol=NESN.S

short-term bond. (2014). In Qatar Financial Center, & Qatar Financial Center (Eds.), QFinance: the ultimate resource (5th ed.). London, UK: A&C Black. Retrieved from https://elibrary.jcu.edu.au/login? url=http://search.credoreference.com/content/entry/qfinance/short_term_bond/0?institutionId=429 Switzerland corporate tax rate. (2017). Retrieved from http://www.tradingeconomics.com/switzerland/corporate-tax-rate The Nestle company history. (2017). Retrieved from http://www.nestle.com/aboutus/history/nestlecompany-history

weighted average cost of capital (WACC). (2003). In B. Etzel, Webster's new world finance and investment dictionary. Boston, MA: Houghton Mifflin Harcourt. Retrieved from https://elibrary.jcu.edu.au/login? url=http://search.credoreference.com/content/entry/wileynwfid/weighted_average_cost_of_capital_wacc/0 ?institutionId=429 5

11. Appendices: Appendix 1-Risk free rate and market-free rate

Market-free rate Risk-free rate

Appendix 2- Corporate tax rate

Appendix 3- Beta rate

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