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Calculating Krispy Kreme's Cost of Capital

Overview

In this chapter we described how to estimate a company's weighted average cost of capital (WACC). Simply put, a company's WACC is a weighted average of the cost of debt, preferred stock, and common equity. Most of the data we need to estimate a company's WACC can be found in Thomson Analytics. Below, we walk through the steps used to calculate an estimate of the cost of capital for Krispy Kreme Doughnuts (KKD).

Discussion Questions

1. As a first step we need to estimate what percentage of KKD's capital comes from long-term debt, preferred stock, and common equity. If we click on FINANCIALS we can see immediately from the balance sheet the amount of KKD's long-term debt and common equity (as of mid-2003, KKD had no preferred stock). Alternatively, you can click on FUNDAMENTAL RATIOS in the next row of tabs below and then select Worldscope's Balance Sheet Ratios. Here, you will also find a recent measure of long-term debt as a percentage of total capital. Recall that the weights used in the WACC are based on the company's target capital structure. If we assume that the company wants to maintain the same mix of capital that it currently has on its balance sheet, what weights should you use to estimate the WACC for KKD? (Note that later in the capital structure chapter, we will see that we might end up with different estimates for these weights if we instead assume that KKD bases its target capital structure on the market values of debt and equity, rather than the book values.)

2. Once again, we can use the CAPM to estimate KKD's cost of equity. Thomson Analytics provides various estimates of beta - select the measure that you think is best and combine this with your estimates of the risk-free rate and the market risk premium to get an estimate of the cost of equity. (See the Thomson Analytics exercise for Chapter 5 for more details.) What is your estimate of KKD's cost of equity? Why might it not make much sense to use the DCF approach to estimate the cost of equity for KKD?

3. Next, we need to calculate KKD's cost of debt. Unfortunately, Thomson Analytics doesn't provide us with a direct measure of the cost of debt. However, we can use a variety of approaches to estimate this cost. One approach is to take the company's long-term interest expense on the income statement and divide it by the amount of long-term debt on the balance sheet. Note, however, that this approach only works if the historical cost of debt equals the yield to maturity in today's market (i.e., if KKD's outstanding bonds are trading at close to their par value). Moreover, this approach may produce misleading estimates in years in which KKD issues a lot of new debt. For example, if a company issues a lot of debt at the end of the year, the full amount of debt will show up on the year-end balance sheet, yet we still may not see a sharp increase in the interest expense on the annual income statement because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach would be to go to the company's annual report. (You can access this through the filings section of Thomson Analytics or click on the link to the company's home page where you then look for the Investor Relations section.) Alternatively, you can go to other external sources to find estimates of the cost of debt. Once you find the cost of debt, remember that you need to multiply this by one minus KKD's tax rate (which has averaged about 38% in recent years) to get the after-tax cost of debt. What do you estimate to be KKD's after-tax cost of debt?

4. Putting all this information together, what is your estimate for KKD's WACC? How confident are you in this estimate?

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