CP
In 1978, while he was taking a course on entrepreneurship as a business student at a large state uni-
versity, Peter Vanderhein wrote a term paper on the management of auto repair shops. Peter’s
uncle owned a repair shop, and Peter had worked for him as well as for several other body shops
when he was in high school and college. Once he began taking business courses, Peter came to rec-
ognize that most shops were inefficient, especially in the way they managed their inventories and
eceivables. This inefficiency resulted in excessive stocks of some items, shortages of others, fre-
quent stock-outs, late payments, bad debt losses, and many dissatisfied customers. Still, in spite of
their inefficiency, the average repair shop appeared to be fairly profitable. Peter concluded that an
opportunity existed to buy inefficient auto repair shops, consolidate them into a concern that was
large enough to use computers to manage inventories and receivables, and thereby increase prof-
itability sharply. He also felt that volume discounts, improved training, and other economies of scale,
would give a further boost to profits.
With encouragement from his family and professors, Vanderhein decided to put his theory to
the test, and in 1979 he started Ace Repair, Inc. Ed Adams, Peter’s uncle, wanted to retire, and he
agreed to sell out subject to a “purchase money mortgage” which would be repaid from the busi-
ness’ cash flow. Peter was also able to bo
ow $100,000 from some family friends, and he a
anged
a $50,000 bank loan secured by the business’ assets. He used this $150,000 to purchase computers
and software, and to train his employees in the use of the new equipment.
Adams agreed to help Peter set things up and then help the shop’s employees adapt to the
new procedures. Everything went well, and profits rose even more rapidly than under Peter’s opti-
mistic forecasts. By early 1981, Peter felt that the bugs were out of his shop management system, so
with Ed’s help, he began to look seriously for additional acquisitions. He took over two new shops
later in 1981, sending employees from the first shop to help run the new ones. The operations of the
acquired shops were as successful as those of the first shop. He bought three additional shops in 1982,
and acquisitions continued at an increasing pace thereafter. By 1995, Ace Repair controlled a total
of 243 shops located throughout the Midwest.
Peter used a mix of securities—common stock, prefe
ed stock, and first mortgage bonds—in
addition to retained earnings to finance acquisitions and open de novo shops, while using trade credit
plus bank loans to help meet working capital needs. Peter has also considered the use of convertible
securities, but to date no convertibles have been issued. Cu
ently, Ace has XXXXXXXXXXmillion com-
Copyright © 1994. The Dryden Press. All rights reserved.
Case 54
Ace Repair, Inc.
Cost of Capital
Directed
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mon shares outstanding, of which Peter owns 17 percent. The stock sells in the over-the-counter mar-
ket for $30.50 per share.
Since the company’s inception, Peter has been directly and tirelessly involved in all facets of
the business. He is satisfied with the service his shops provide, with the company’s inventory and
eceivables management, and with the marketing aspects of the business. However, he has become
increasingly uneasy about the finance function, in which he has no special expertise. The controlle
has overseen most financial matters, but with the rapid growth in the scope and size of the busi-
ness, financial decisions have become increasingly complex. Further, competition from large cor-
porations such as Sears, Wal-Mart, and auto dealerships has been increasing. So, by 1995,
Vanderhein concluded that to ensure continued success, he must establish a finance group that was
as competent and sophisticated as those of his competitors. Therefore, in late 1995, he hired Adam
Naranjo, a senior financial executive with a major retail chain, as vice president and chief financial
officer (CFO).
Naranjo began by reviewing the existing capital investment procedures. After going over the
procedures manuals and the supporting analyses for recent capital investment decisions, he con-
cluded that the overall procedures were generally appropriate: The firm relied on discounted cash
flow criteria to a
ive at accept
eject decisions for most projects; it estimated future cash flows on
an incremental basis; and it discounted cash flows at the firm’s weighted average cost of capital
(WACC). However, the estimate of the cost of capital itself was questionable.
In the most recent capital budgeting exercise, at year-end 1995, the controller used a before-
tax debt cost of 10 percent, which was equal to the coupon rate on Ace’s last XXXXXXXXXXlong-term first
mortgage bond issue. These bonds are rated single A, will mature in 17 years, and can be called in
3 years. For the cost of equity, the controller used the year-end earnings yield (E/P) of 7.5 percent,
ased on an earnings per share of $2.30 and a share price of $30.50. His justification for using the
E/P yield was that since investors were getting $2.30 of earnings for a $30.50 investment, they
were willing to accept a 7.5 percent rate of return on their money. Also, the controller noted that if
the company could sell stock for $30.50 per share and then invest the proceeds at a 7.5 percent rate
of return, earnings per share would remain at $2.30. He also noted that this 7.5 percent is an after-tax
cost, and it is below the after-tax cost of debt. Of course, the controller wants the company to sell
stock only to finance projects that will earn more than the 7.5 percent cost of equity, hence will
increase earnings per share. Table 4 (2) contains the quotation of the company’s prefe
ed stock. This
security has a par value of $100 and new issues would have a flotation cost of $2.50 per share.
Given estimates of the capital components’ costs, the controller calculated the WACC on the
asis of weights as determined from the balance sheet shown in Table 2. These book value weights
differ from the market value weights and from the company’s target capital structure as reported in
Table 4, part 11.
In early January 1996, Naranjo decided to hire your consulting firm to conduct a cost of cap-
ital analysis and to make a critical evaluation of the cu
ent estimation procedures. Naranjo provided
you with the financial statements given in Tables 1 and 2, plus the information in Tables 3 and 4.
You must critique Ace’s cu
ent procedures for estimating the costs of debt and equity, and
then use the data to estimate Ace’s component costs of capital, WACC, and marginal cost of capi-
tal schedule. You must also decide whether to use your estimate of the marginal weighted average
cost of capital as the hurdle/discount rate for all of the firm’s projects.
Naranjo is also interested in your views on the weights used to calculate the WACC. The con-
troller has been using book weights based on the actual capital structure, but considering long-term
capital only. His reasoning was that this is the way the capital used for capital budgeting purposes
has actually been raised, and also that Moody’s, S&P, and all security analysts whose reports he has
seen focus on actual capital structures based on actual accounting statements. He chose not to use mar-
ket value weights in part because investors apparently do not focus on market value weights, and
also because market value weights would be unstable, hence would result in a fluctuating WACC, and
as a result would destabilize the capital budgeting process. He has toyed with the idea of using the
© 1997 South-Western, a part of Cengage Learning
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target capital structure weights, but he co
ectly pointed out that the targets have never been attained,
and there is no reason to expect them to be attained anytime soon. Naranjo wants your opinion on (1)
what weights should be used, and (2) how much difference the choice of weights would make in
the calculated WACC.
If Naranjo likes your report—if he thinks it is logical, technically co
ect, and well presented—
he will hire your firm for other consulting assignments and recommend you to his friends. He
might even offer you the job as treasurer of Ace Repair. In any event, a well-received report will give
your career a big boost, so you want to do a good job. To help structure your analysis and report,
answer the following questions.
QUESTIONS
1. a. Discuss the specific items of capital that should be included in the WACC.
. The comptroller cu
ently finds the weights for the weighted average cost of capital
(WACC) from information from the balance sheet shown in Table 2. Compute the book
value weights that the comptroller cu
ently uses for the company’s capital structure.
c. Based on the suggestion that the focus should be on market values, compute the weights
of debt, prefe
ed stock, and common stock.
d. Are book value or market value weights better for calculating the firm’s weighted aver-
age cost of capital?
2. a. Critique Ace Repair’s cu
ent method of estimating its before-tax cost of debt.
. Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity?
3. a. What is the best estimate of Ace’s cost of debt?
. Should flotation costs be included in the component cost of debt calculation? Explain.
c. Should the nominal cost of debt or the effective annual rate be used? Explain.
d. How valid is an estimate of the cost of debt based on the yield to maturity of Ace’s debt
(ignore the call provision in 3 years) if the firm plans to issue 20-year long-term debt?
e. What other methods could be used to estimate the cost of debt if, for example, Ace’s out-
standing debt had not been traded recently?
4. a. What is Ace’s cost of prefe
ed stock?
. Ace’s prefe
ed stock is more risky to investors than its debt, yet the before-tax yield on
its prefe
ed is lower than the yield on A-rated debt issues. Why does