Estimate The McCormick & Company's WACC And Make A Recommend

Estimate the McCormick & Company's WACC and make a recommen

To evaluate McCormick & Company’s capital budgeting projects accurately, it is crucial to estimate its Weighted Average Cost of Capital (WACC). The WACC reflects the average rate that the company must pay to finance its assets through debt and equity, adjusted for the relative proportions and risks associated with each source. Given recent changes in interest rates, the acquisition of RB Foods, and updated capital structure details, a thorough assessment of the current WACC is essential. This paper discusses the calculation of McCormick & Company’s WACC based on the latest financial data, estimates of the cost of equity using multiple methods, and the implications for corporate decision-making, especially considering the increased interest rates and changes in the capital structure.

Paper For Above instruction

Estimating McCormick & Company’s Weighted Average Cost of Capital (WACC) is a vital step in ensuring that the company's investment and project evaluation are aligned with current market conditions and financial health. The WACC serves as a critical discount rate used in capital budgeting to determine the net present value (NPV) and internal rate of return (IRR) of potential investments. Recent changes, such as rising interest rates, the acquisition of RB Foods, and shifts in debt and equity proportions, necessitate a reassessment of the company's cost of capital to make informed financial decisions.

The calculation begins with determining the components of the company's capital structure. As per the latest financial statements, McCormick & Company’s market value of equity stood at approximately $17.5 billion as of February 2019. The firm's debt obligations consist of short-term borrowings, the current portion of long-term debt, and long-term debt, totaling about $4.696 billion based on book values from the 2019 balance sheet. These figures are critical as they serve as the basis for calculating the capital proportions used in WACC.

The cost of debt is assumed to be 4%, reflecting current market rates for the firm’s debt instruments, and is adjusted for the corporate tax rate of 27.5%, following standard practice that recognizes the tax shield benefits of debt. The component of debt in the capital structure, as derived from the book value, amounts to approximately 21% of total financing, while equity constitutes roughly 79%. These proportions are used in the WACC formula:

WACC = (W_D) x R_D x (1 - T) + (W_S) x R_S

where W_D and W_S are the weights of debt and equity, respectively; R_D and R_S are their respective costs.

Next, the cost of equity (R_S) is estimated using multiple approaches to ensure robustness. The most commonly used method is the Capital Asset Pricing Model (CAPM). Based on the latest data, the risk-free rate (r_RF) is 3%, derived from the 30-year bond rate, which reflects long-term investor expectations. The beta coefficient, a measure of the stock’s sensitivity to market movements, is reported as 0.01—an exceptionally low figure indicative of minimal systematic risk, although this may be a data anomaly or misstatement. Assuming a more realistic beta in the range of 0.8 to 1.0, an average market risk premium (RPM) of 6% is used, aligning with contemporary estimates.

Applying CAPM, the cost of equity would be:

R_S = r_RF + (Beta) x RPM

Supposing we adopt a beta of 0.8, then:

R_S = 3% + 0.8 x 6% = 3% + 4.8% = 7.8%

Alternatively, the dividend Discount Model (DCF) provides an estimation based on expected dividends and growth. With a current dividend (D₁) of $2.38, a stock price (P₀) of $135, and an expected growth rate (g) of 7%, the cost of equity using the DCF approach is:

R_S = (D₁/P₀) + g = (2.38 / 135) + 7% ≈ 1.76% + 7% = 8.76%

This method suggests a higher cost of equity than CAPM, highlighting differences based on investor expectations and dividend growth assumptions.

Another simplified approach is to add a risk premium (3% to 5%) to the company's debt interest rate, which is 4%. Management’s estimate suggests:

Cost of equity ≈ Cost of debt + Risk premium = 4% + 4% (average of 3% and 5%) = 8%

Given these estimates, selecting a final cost of equity involves balancing the conservative CAPM projection, the dividend model, and the premium-based estimate. The most appropriate figure for McCormick, considering its dividend-paying status and stable market position, appears to be the dividend model estimate of 8.76%, with acknowledgment of the broader context and investor expectations.

Once the cost of equity is established, the WACC calculation involves integrating the component weights. As noted, the market value of equity is $17.5 billion, while debt totals approximately $4.696 billion, making the total capital roughly $22.196 billion. The weights are therefore:

W_D = 4.696 / 22.196 ≈ 0.21 or 21%

W_S = 17.5 / 22.196 ≈ 0.79 or 79%

Applying the known cost of debt (4%) and the estimated cost of equity (8.76%), the WACC formula becomes:

WACC = 0.21 x 4% x (1 - 0.275) + 0.79 x 8.76% = 0.21 x 4% x 0.725 + 0.79 x 8.76%

Calculating each component:

Debt contribution: 0.21 x 4% x 0.725 ≈ 0.21 x 0.04 x 0.725 ≈ 0.0061 or 0.61%

Equity contribution: 0.79 x 8.76% ≈ 0.79 x 0.0876 ≈ 0.0692 or 6.92%

Summing these gives:

WACC ≈ 0.61% + 6.92% ≈ 7.53%

This represents the firm's current cost of capital, which can be used as the discount rate for capital budgeting decisions.

Considering the previous discount rate of 7%, and the new estimate of approximately 7.53%, we recommend updating the discount rate to at least 7.5%. The increase reflects the higher current interest environment and the recent acquisition activities, ensuring future projects are evaluated against a more accurate cost of capital that aligns with prevailing market conditions.

In conclusion, the refined WACC for McCormick & Company, calculated at approximately 7.53%, provides a more realistic benchmark for assessing investment opportunities. This adjustment supports prudent financial management and strategic decision-making, maintaining alignment with the company's long-term capital costs and risk profile.

References

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