In its annual report, discloses the following:
Financial Objectives: Provide total shareholder returns (dividends plus share price appreciation) that exceed both the cost of equity and the S&P 500 stock index over time. Quaker’s total return to shareholders for Year 11 was 34%. That compares quite favor- ably to our cost of equity for the year, which was about 12%, and to the total return of the S&P 500 stock index, which was 7%. Driving this strong performance, real earnings from continuing operations grew 7.4% over the last five years, return on equity rose to
24.1%. [Quaker Oats’ stock price at the beginning and end of Year 11 was $48 and $62, respectively, and the Year 11 dividends are $1.56 per share.]
The Benchmark for Investment
We use our cost of capital as a benchmark, or hurdle rate, to ensure that all projects un- dertaken promise a suitable rate of return. The cost of capital is used as the discount rate in determining whether a project will provide an economic return on its investment. We estimate a project’s potential cash flows and discount these cash flows back to present value. This amount is compared with the initial investment costs to determine whether incremental value is created. Our cost of capital is calculated using the approximate market value weightings of debt and equity used to finance the Company.
Cost of equity + Cost of debt = Cost of capital
When Quaker is consistently able to generate and reinvest cash flows in projects whose returns exceed our cost of capital, economic value is created. As the stock market evaluates the Company’s ability to generate value, this value is reflected in stock price appreciation. The cost of equity. The cost of equity is a measure of the minimum return Quaker must earn to properly compensate investors for the risk of ownership of our stock. This cost is a combination of a “risk-free” rate and an “equity risk premium.” The risk-free rate (the
U.S. Treasury Bond rate) is the sum of the expected rate of inflation and a “real” return of 2% to 3%. For Year 11, the risk-free rate was approximately 8.4%. Investors in Quaker stock expect the return of a risk-free security plus a “risk premium” of about 3.6% to compensate them for assuming the risks in Quaker stock. The risk in holding Quaker stock is inherent in the fact that returns depend on the future profitability of the Company. Quaker’s cost of equity was approximately 12%. The cost of debt. The cost of debt is simply our after-tax, long-term debt rate, which was around 6.4%.
Required:
a. Quaker reports the “return to shareholders” to be 34%.
(1) How is this return computed (provide calculations)?
(2) How is this return different from return on common equity?
b. Explain how Quaker Oats arrives at a 3.6% “risk premium” needed by common shareholders as compensation for assuming the risks of Quaker Oats’ stock.
c. Explain how Quaker Oats determines the 6.4% cost of debt.