In 1978, while he was taking a course on entrepreneurship as a business student at a large state university,Peter Vanderhein wrote a term paper on the management of auto repair shops. Peter’suncle owned a repair shop, and Peter had worked for him as well as for several other body shopswhen he was in high school and college. Once he began taking business courses, Peter came to recognizethat most shops were inefficient, especially in the way they managed their inventories andreceivables. This inefficiency resulted in excessive stocks of some items, shortages of others, frequentstock-outs, late payments, bad debt losses, and many dissatisfied customers. Still, in spite oftheir inefficiency, the average repair shop appeared to be fairly profitable. Peter concluded that anopportunity existed to buy inefficient auto repair shops, consolidate them into a concern that waslarge enough to use computers to manage inventories and receivables, and thereby increase profitabilitysharply. 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 tothe test, and in 1979 he started Ace Repair, Inc. Ed Adams, Peter’s uncle, wanted to retire, and heagreed to sell out subject to a “purchase money mortgage” which would be repaid from the business’cash flow. Peter was also able to borrow $100,000 from some family friends, and he arrangeda $50,000 bank loan secured by the business’ assets. He used this $150,000 to purchase computersand 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 thenew procedures. Everything went well, and profits rose even more rapidly than under Peter’s optimisticforecasts. By early 1981, Peter felt that the bugs were out of his shop management system, sowith Ed’s help, he began to look seriously for additional acquisitions. He took over two new shopslater in 1981, sending employees from the first shop to help run the new ones. The operations of theacquired 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 totalof 243 shops located throughout the Midwest.
Peter used a mix of securities—common stock, preferred stock, and first mortgage bonds—inaddition to retained earnings to finance acquisitions and open de novo shops, while using trade creditplus bank loans to help meet working capital needs. Peter has also considered the use of convertiblesecurities, but to date no convertibles have been issued. Currently, Ace has 6.2261 million com-Copyright © 1994. The Dryden Press. All rights reserved.mon shares outstanding, of which Peter owns 17 percent. The stock sells in the over-the-counter marketfor $30.50 per share.
Since the company’s inception, Peter has been directly and tirelessly involved in all facets ofthe business. He is satisfied with the service his shops provide, with the company’s inventory andreceivables management, and with the marketing aspects of the business. However, he has becomeincreasingly uneasy about the finance function, in which he has no special expertise. The controllerhas overseen most financial matters, but with the rapid growth in the scope and size of the business,financial decisions have become increasingly complex. Further, competition from large corporationssuch 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 wasas competent and sophisticated as those of his competitors. Therefore, in late 1995, he hired AdamNaranjo, a senior financial executive with a major retail chain, as vice president and chief financialofficer (CFO).
Naranjo began by reviewing the existing capital investment procedures. After going over theprocedures manuals and the supporting analyses for recent capital investment decisions, he concludedthat the overall procedures were generally appropriate: The firm relied on discounted cashflow criteria to arrive at accept/reject decisions for most projects; it estimated future cash flows onan 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 beforetaxdebt cost of 10 percent, which was equal to the coupon rate on Ace’s last (1993) long-term firstmortgage bond issue. These bonds are rated single A, will mature in 17 years, and can be called in3 years. For the cost of equity, the controller used the year-end earnings yield (E/P) of 7.5 percent,based on an earnings per share of $2.30 and a share price of $30.50. His justification for using theE/P yield was that since investors were getting $2.30 of earnings for a $30.50 investment, theywere willing to accept a 7.5 percent rate of return on their money. Also, the controller noted that ifthe company could sell stock for $30.50 per share and then invest the proceeds at a 7.5 percent rateof return, earnings per share would remain at $2.30. He also noted that this 7.5 percent is an after-taxcost, and it is below the after-tax cost of debt. Of course, the controller wants the company to sellstock only to finance projects that will earn more than the 7.5 percent cost of equity, hence willincrease earnings per share. Table 4 (2) contains the quotation of the company’s preferred stock. Thissecurity 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 thebasis of weights as determined from the balance sheet shown in Table 2. These book value weightsdiffer 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 capitalanalysis and to make a critical evaluation of the current estimation procedures. Naranjo providedyou with the financial statements given in Tables 1 and 2, plus the information in Tables 3 and 4.You must critique Ace’s current procedures for estimating the costs of debt and equity, andthen use the data to estimate Ace’s component costs of capital, WACC, and marginal cost of capitalschedule. You must also decide whether to use your estimate of the marginal weighted averagecost 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 controllerhas been using book weights based on the actual capital structure, but considering long-termcapital only. His reasoning was that this is the way the capital used for capital budgeting purposeshas actually been raised, and also that Moody’s, S&P, and all security analysts whose reports he hasseen focus on actual capital structures based on actual accounting statements. He chose not to use marketvalue weights in part because investors apparently do not focus on market value weights, andalso because market value weights would be unstable, hence would result in a fluctuating WACC, andas a result would destabilize the capital budgeting process. He has toyed with the idea of using theCase: 04BD Cost of Capital
target capital structure weights, but he correctly 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 inthe calculated WACC.
If Naranjo likes your report—if he thinks it is logical, technically correct, and well presented—he will hire your firm for other consulting assignments and recommend you to his friends. Hemight even offer you the job as treasurer of Ace Repair. In any event, a well-received report will giveyour 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.
b. The comptroller currently finds the weights for the weighted average cost of capital(WACC) from information from the balance sheet shown in Table 2. Compute the bookvalue weights that the comptroller currently uses for the company’s capital structure.

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