3.1 Topical Case: Wulfurt Family Chocolates Cost of Capital

The Wulfurt family from Dusseldorf, Germany has been making chocolates for generations. The Wulfurt family’s secrets to making dozens of different types of chocolates are something any entrepreneur would like to get his hands on. Henrietta Wulfurt spent many hours over the holidays as a teenager learning how to make the famous family chocolates from her mother. While taking an entrepreneurship class in college, Henrietta realized the potential business that her family’s chocolates could make. She envisioned that one day her family secrets could turn into a famous global brand.

The Beginning

After college, Henrietta opened the first Wulfurt Family Chocolates shop in West Dusseldorf. Years before the shop even opened, the Wulfurt family name was famous in Dusseldorf for making tasty chocolates. Henrietta had no problem finding customers, and the store quickly outgrew its capacity. She hired a man named Heirich Muller to run the finances for the company. Heirich was levelheaded and was considered neither conservative nor a risk taker. Henrietta, on the other hand, was a risk taker. When dealing with the expansion of Wulfurt Family Chocolates, Heirich often advised Henrietta to avoid certain projects because of the high required rate of return. Henrietta didn’t mind the risk and sometimes authorized investments that had a 35% required rate of return. Luckily for her, the rapid company growth helped her achieve her returns.

Incorporation

In 20X0, Henrietta decided to retire and moved to Hawaii. Her son Freidrich took over the family business. Although he truly believed in the superiority of his family chocolates, he was more concerned about profit margins and reducing risk. A few years after his mother’s retirement, Freidrich announced that Wulfurt Family Chocolates was going public. Freidrich preferred to go public so he could pass on the risk to shareholders as well as raise capital to open up a factory.

In order to achieve the capital it needed, Wulfurt Family Chocolates sold issuances of 1) a 10-year coupon bond which has a yield to maturity of 6.5%, 2) preferred stock, and 3) common stock on the open market.

The company began offering stocks and bonds on the open market in Germany in 20X2. Four years after incorporating, things were not going as well as planned for Freidrich and Wulfurt Family Chocolates. In 20X5, sales for the company had reached a peak of €210 million, and since leveled off. Meanwhile, net income for the company slowly declined.

One day Freidrich approached Heirich and announced to him that Big Choc Inc. had interest in merging the two companies. He said, “Before the merger is complete, Big Choc is requesting some financial numbers from us. Oh, and don’t worry, I ensured your job security.” Freidrich asked Heirich to determine Wulfurt Family Chocolate’s cost of capital.

Financial Information

Heirich set to work trying to gather all the financial information he needed to complete his calculations for the merger. He called up a friend who is a financial analyst for the German stock market and asked him to calculate beta for the company’s common. The next day his friend called back and informed him that the beta for common stock is around 0.7. Heirich also checked the stock market to see what a share of common stock and preferred stock were selling for. A share of common stock was selling for €9.10, and a share of preferred stock was selling for €15.25. The preferred stock also paid a constant dividend of €1.07.

Heirich looked on the internet to determine the historical average return on the stock market and the current return. He also located the return on a 30-year government bond. Heirich pulled up the earnings per share, dividends paid for the past three years, and last year’s balance sheet. The information Heirich had available for his calculation is listed in Figure 9-6 and Figure 9-7. Despite the decrease in dividend growth, Heirich believes that the Big Choc merger will bring about a renewed growth in the company. He predicts the growth in future dividends for common stock to be the average of the percent change in dividends (starting when the company began offering stocks and bonds in the open market in Germany) 20X2-20X7 as shown in Figure 9-8.

Notes

• The company’s cost of capital will be the weighted average of the required rate of return on each financing source.
• Ignore flotation costs.
• The market value of Wulfurt Family Chocolate’s bonds is €54,800,000.
• Wulfurt has 30 million common shares outstanding.
• Wulfurt has 2 million preferred shares outstanding.
• The interest rate on Wulfurt Family Chocolate’s notes payable is 6.5%. The market value of the notes payable is equal to the value shown on their balance sheet.
• Assume a 34% corporate tax rate.
• The company’s growth rate is equal to the dividend growth rate.

Figure 9-6: Historical Average Annual Returns on Investments

Figure 9-7: Wulfurt Family Chocolate Balance Sheet (Liabilities & Equity Section)

Figure 9-8: Earnings Per Share and Dividends Per Share on Wulfurt Family Common Stock

Questions

1. What are the weights for each capital source using book values? Using market values? What advantages does using the book value have when determining the cost of capital? What advantages does using the market value have?
2. What is Wulfurt Family Chocolates’ after-tax cost of debt on the notes payable and bonds?
3. Use the dividend valuation model to determine the cost of common and preferred equity.
4. Use the CAPM approach to calculate the required rate of return for the common stock. Why do the common stock estimates differ between the dividend model and the CAPM?
5. Calculate the weighted average cost of capital for Wulfurt Family Choco- lates using market weights. Use the CAPM rate for the cost of common stock.
6. If Wulfurt Family Chocolates becomes more leveraged,shouldthecompany adjust beta upwards or downwards? Why?
7. Henrietta was a risk taker while her son Freidrich wasn’t. What challenges or disadvantages would a company have that was a risk taker in terms of cost of capital and investments? What about the challenges or disadvantages under Freidrich?