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UVA-F-0982 Mead Corporation: Cost Of Capital
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UVA-F-0982
MEAD CORPORATION: COST OF CAPITAL
On February 14, 1991, Cheryl Harris, business analyst at Mead Corporation, had just begun the process of estimating Mead’s cost of capital for the fourth quarter of 1990. Like most other major corporations, Mead used its weighted-average cost of capital (WACC) to evaluate new investment proposals as well as to measure corporate and divisional performance. Mead was unique, however, in its practice of updating the hurdle rate every quarter and analyzing the factors responsible for its change. Looking back at the company’s history of WACC estimates, Ms. Harris observed that Mead’s cost of equity had been increasing relative to its cost of debt over the past few years. Hence, as part of her analysis, she hoped to explain why the cost of equity had increased and recommend whether the company should consider the increase a problem. Her more immediate concern, however, was the presentation she was to give the next morning to William Enouen, Mead’s chief financial officer, who had asked to see Ms. Harris’s WACC estimate.
Mead Corporation
Mead Corporation was founded in 1846 by Daniel E. Mead and incorporated in 1930. In the ensuing years, Mead, Inc., grew to become a leading producer of paper and forest products. Included in the company’s product line of forest derivatives were printing paper, writing paper, specialty paper, lumber, wood pulp, corrugated containers, and packaging products. The company also owned and operated a national distribution network for paper packaging and supplies. For beverage packages and packaging systems as well as for paper-based school and office supplies, Mead was the leading manufacturer in the United States. In addition to its forest and paper-based products, Mead had been involved in electronic publishing and the development of color imaging. Mead Data Central (MDC), a wholly owned subsidiary of Mead, Inc., owned several publishing companies--for example, The Michie Company in Charlottesville, Virginia, which published and distributed the legal statutes of 23 states. MDC also marketed the LEXIS® and NEXIS® information services. LEXIS was a computer-based dataretrieval system designed for legal research that had been expanded to include financial information from leading investment banks, brokerage firms, and research companies. NEXIS was an on-line
This case was prepared by Kenneth Eades for the purposes of classroom discussion. Some figures have been changed at the request of the company. Copyright 1991 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any f orm or by any means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 5/95. ◊
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UVA-F-0982
general-information-retrieval service frequently available in libraries and news depa rtments of the print and broadcast media. After having invested approximately $200 million over five years in the development of its color-imaging process called Cycolor®, Mead had announced in December 1990 that the demand for color copying was growing too slowly to justify remaining in the business. The writeoffs associated with the discontinuance had resulted in Mead’s fourth-quarter earnings per share falling from the third-quarter figure of $0.63 to $0.17. The company projected that the writeoffs would be completed before the second quarter of 1991, at which time profits were expected to return to normal. The announcement regarding discontinuation of its color-imaging business did not appear to have adversely affected Mead’s common stock price, which had risen to $25.75 on December 31, 1990, from $24.25 on October 1, 1990.
Mead’s Cost of Capital
Mead had conducted an internal study in 1984 of the company’s cost-of-capital calculation method. Subsequently, top management implemented a strategy to estimate the cost of capital each quarter and decompose it into its components for comparison with historical estimates. The cost of capital had become an important benchmark for measuring both corporate and divisional performance. Although several other factors were used in the evaluation of Mead’s divisions, earning a return on investment greater than the cost of capital was considered the single most important performance measure. One of the recommendations of the study was that the MDC division, because of its higher risk, should be held to a higher required rate of return standard than the rest of the company’s divisions. Thus, while the other divisions were evaluated against the company’s WACC, MDC’s performance was compared with Mead’s WACC plus an additional 4 percent.1 The same 4 percent risk premium had been used for MDC’s cost of capital since 1984. In addition to measuring internal performance, the cost of capital also served as a barometer of the external market’s perception of the company. For example, the cost of equity reflected the market’s assessment of the company’s risk. If senior management’s assessment of Mead’s risk was substantially less than the market’s, the company could take advantage of the market’s pricing by executing a share-repurchase program. Following the stock market crash in 1987, Mead repurchased approximately 282,000 shares on the open market. In 1990, the company repurchased 5.0 million shares at an average price of $26.69, which approximated the company’s 1990 book value of $26.28 per share. Studying the components of the WACC allowed management to discriminate between changes in capital costs caused by macroeconomic variables such as interest rates and changes caused by firm-specific variables such as the company’s beta or its capital structure. Changes in firm-specific variables were considered to be somewhat under management’s control, whereas a
1
Casewriter’s estimate.
