Purpose: To apply the Capital Asset Pricing Model, the Bond Pricing Model and the Dividend Growth Model to obtain estimates of the cost of capital for Ecolab corporation, both under its current capital structure and its target capital structure.

Problem Facts and Information:

It is the beginning of November 2016, and the Ecolab (ECL) Corporation is considering a major investment project that will have a life of 10 years.1 You are on the team to find the Net Present Value of the project. Others are estimating the cash flows required for the analysis. Your job is to estimate ECLs cost of capital to be used to discount the cash flows. Because of the estimated 10-year life of the project, you are to estimate the cost of capital for financing over a horizon of approximately 10 years.

ECL has previously issued long term bonds to fund at least a part of this kind of project. Recently, however, the Board of Directors has established a target capital structure that is less highly leveraged than the current actual capital structure. You will be asked to compute ECLs weighted average cost of capital at both the current amount of leverage, and the target amount.

To compute the weighted average cost of capital, you will need to compute the cost of equity and the cost of debt. As a reality check you are asked to calculate each of these costs by two different methods:

Cost of Debt:

Method 1: Capital Asset Pricing Model

Method 2: Estimating the Yield to Maturity on a current ECL long-term bond

_{1 Many of the financial numbers in this assignment are based on actual analysis of Ecolab Corporation done by ValueLine (March 2017), Yahoo finance, and bonds listed in the FINRA bond database. Apart from that, this problem is fictional.}

Cost of Equity:

Method 1: Capital Asset Pricing Model

Method 2: Dividend Growth Model

You have the following information to work with: Data relevant to debt:

Assume that today is 11/01/2016 (i.e., this is the date of your analysis)

The current price quote on a ECL long term bond issue with Maturity

11/01/2026 is $996.16 (quoted as $99.616 per $100 par value). The bond has a par value of $1000, a coupon rate of 2.70%, and semi-annual coupon

payments. [You will use the YTM for this bond as an estimate of the interest rate required for debt financing.]

ECLs marginal corporate tax rate is 34%

It has been estimated that ECLs debt beta (B) is 0.100. Assume that this debt beta is constant even when leverage increases.

Data relevant to equity:

ECL has a current common stock price of $124.03 per share.

It is anticipated next annual dividend will be $1.48 per share. (This is roughly consistent with its recent dividend payout rate of 29% of earnings, and a P/E ratio of

26.7).

The consensus of analysts following ECL is a forecast of a long-term growth rate of 11.00% per year (lower than the 13% in the most recent 10 years).

It has been estimated that ECLs equity beta (S) is 1.074.

Long-term market data relevant to the CAPM

As an estimate of the current 10-year risk free interest rate, you see that 10-year

US Treasury bonds are being quoted at a yield of 1.72%

Estimates of the long-term average market risk premium will be based on the result that large-company stocks have averaged an 11.80% return over the period 1926-2011. Thus, we will estimate the market risk premium as (11.80%

- 1.72%) = 10.08%

Data relevant to capital structure:

ECLs current actual capital structure is 37% debt, 63% equity.

ECLs target capital structure is 25% debt, 75% equity.

Questions to Answer (Show your work)

Give % answers to 2 decimal points [e.g., x.xx%] and s to 3 decimal points. [e.g., x.xxx])

1. What is ECLs cost of debt, RB , as estimated by:

a. the CAPM ?2

b. the YTM on the bond discussed above?3

2. What is ECLs cost of equity, RS , as estimated by:

a. the CAPM4

b. the Dividend Growth Model (DGM)?5

3. What is ECLs weighted average cost of capital, RWACC , at its current capital structure?6

4. What is:

a. ECLs equity beta, *S , at the target capital structure?7

b. ECLs equity cost of capital, R*S, at the target capital structure?

5. Explain, qualitatively, why Beta and the cost of equity changed in the direction that they did.

6. What is ECLs weighted average cost of capital, R*WACC, at the target capital structure?

Suggestion: Do the computations using the CAPM first, (i.e., Questions 1a. and 2a. followed by 3, 4,5 and 6) then return to do 1b. and 2b. to see if you get similar results for the costs of equity and debt. I.e., you only need to do questions 3-6 using the costs of debt and equity obtained from the CAPM

2 Hint: See slide 5 in the Module06b_Cost_of_Capital slides for a guide. Use the given yield on the 7-year treasury security as the risk free rate, and estimate the risk premium as the long term difference between the return on large cap stocks and the risk free rate.

3 Hint: See slide 12 in the Module05a_Bond_Valuation slides for a guide on how to do this on a calculator. It can also be done in Excel using the RATE function (or the YIELD function. See the built-in help for this function).

4 See slide 5 in the Module06b_Cost_of_Capital slides for a guide. Also see footnote 2 above re: risk free rate and market risk premium.

5 Hint: See slide 6 in the Module06b_Cost_of_Capital slides for a guide. Take the dividend stated above as D1 plus the current stock price and the forecasted growth rate to estimate the cost of equity based on the dividend growth model

(DGM).

6 See slide 20 in the Module06b_Cost_of_Capital slides for a guide.

7 For this and the remaining questions, see the discussion and example in slides 27-34 in the

Module06b_Cost_of_Capital slides.