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Procter & Gamble Analysis

David Hatfield
East Carolina University
FINA 4734
Dr. Jaclyn Beierlein
Table of Contents
Introduction 1
Financial Statement Analysis 2
Cost of Capital 9
Optimal Capital Structure 18
Dividend Policy 23
Bankruptcy Analysis 29
Corporate Governance 30
Conclusion 33
Works Cited 34
Introduction

The purpose of this analytical paper is to provide estimations, interpretations, and


conclusions found while examining the company Procter & Gamble. Procter & Gamble is
listed under the household products industry and is the largest firm in its industry. The
firm has five main business segments: beauty, grooming, health care, fabric care & home
care, and baby, feminine & family care. The product list is extensive and contains many
familiar name brands such as Olay, Gillette, Crest, Febreze, and Pampers. Key industry
competitors of the firm include Johnson & Johnson, Kimberly-Clark Holdings, Colgate-
Palmolive Co., and Clorox Co. Procter & Gamble provides products in over 180
countries, 66% of its total market being the United States and Europe. The firm has
settled in the mature growth stage of its total lifecycle. Dr. Aswath Damodaran, the
author of Applied Corporate Finance, is a finance professor at the Stern School of
Business at New York University. Dr. Damodaran’s text, data tables, articles, and
methods of corporate finance were used extensively in this analysis of Procter & Gamble.
Mergent Online, a business and financial information website, was the primary source of
Procter & Gamble’s financial data. Yahoo Finance and Morningstar Investment Research
Center were also used for research and data gathering. The following pages of this
analysis will cover many areas of corporate finance. The sections of this paper, financial
statement analysis, cost of capital, optimal capital structure, dividend policy, bankruptcy
analysis, and corporate governance, are titled to represent the research and findings for
each section.

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Financial Statement Analysis
Introduction
The subsequent financial statement analysis of Procter & Gamble will provide an
evaluation of the firm’s financial ratios. This analysis will cover four groups of financial
ratios, liquidity and turnover, leverage and coverage, profitability, and market value, each
group structured into its own table. The following seven industry competitors were used
for calculation of the ratio averages: Johnson & Johnson, Kimberly-Clark Holdings Ltd.,
Colgate-Palmolive Co., Ecolab Inc., Sealed Air Corp., The Clorox Co., and Church &
Dwight Company Inc. Mergent online had included four additional competitors in its list.
These competitors were removed from the list due to their low reported revenue in
respect to Procter & Gamble. Procter & Gamble has a fiscal year ending June 30th thus
financial information for 2015 is available for analysis. For this analysis, the firm’s
financial ratios for the year 2015 were excluded from examination. Averages for
competitors’ liquidity, leverage, and profitability ratios were skewed from a lack of data
for the year 2015. These averages did not provide a reliable benchmark to compare
Procter and Gamble to its industry, resulting in the following financial analysis covering
the years 2010 through 2014. Mergent online was the source of the financial data, ratios,
and competitor information used in this analysis of Procter & Gamble. The firm and
industry growth rates shown in a table below were gathered from Reuters.com. The
purpose of this financial statement analysis, of Procter & Gamble, is to analyze its
financial strengths and weaknesses to provide an evaluation of its overall financial health.

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Liquidity and Turnover Ratios
Liquidity and Turnover
2014 2013 2012 2011 2010
Procter & Gamble Co. 0.94 0.80 0.88 0.80 0.77
Current Ratio
Average 1.31 1.43 1.34 1.59 1.33
Procter & Gamble Co. 0.51 0.41 0.42 0.33 0.34
Quick Ratio
Average 0.82 0.93 0.88 1.10 0.89
Procter & Gamble Co. -1.46 -4.34 -2.27 -3.85 -4.29
Net Current Assets/TA%
Average 5.75 8.71 5.56 10.47 6.85
Procter & Gamble Co. 21.92 17.23 16.57 15.88 14.65
Current Assets/TA%
Average 33.14 33.19 31.40 32.55 43.18
Procter & Gamble Co. 2.69 3.60 3.74 3.90 4.09
Current Asset TO
Average 2.88 2.73 2.84 2.75 2.37
Procter & Gamble Co. 4.69 4.96 5.08 5.33 4.98
Inventory/TA%
Average 8.53 8.19 7.52 7.40 8.21
Procter & Gamble Co. 6.21 6.23 6.01 5.92 5.72
Inventory TO
Average 6.10 6.11 6.12 5.92 6.20
Procter & Gamble Co. 15.46 15.56 15.41 15.39 15.01
PPE/TA%
Average 22.15 21.25 17.94 17.85 20.95
Procter & Gamble Co. 3.78 4.00 4.01 4.07 4.08
PPE/TO
Average 4.93 5.18 5.07 4.79 4.95
Procter & Gamble Co. 0.59 0.62 0.62 0.62 0.60
Total Asset TO
Average 0.95 0.91 0.89 0.90 1.03

The current ratio of the firm increases by 22% from the year 2010 to 2014 but remains
below the industry average over time. The quick ratio provides similar results and is well
below the industry average for the 5 years of examination. The percentage increase for
the quick ratio from year 2010 to 2014 of 50% indicates that the firm became much more
liquid over the 5 years. These liquidity ratios show that Procter & Gamble would not be
able to pay off its short-term obligations with its current assets. The provided net current
assets over total assets resulted in negative percentages spanning the entire 5 years of
data. The causation of these negative percentages is from the firm having more current
liabilities than current assets. The negative percentages are difficult to compare against

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the positive industry average. Further calculation of the net current asset turnover
provided more confusing negative results, thus net current asset turnover was excluded.
To compensate, more data from Mergent online was used. Current assets and total assets
for each company over the 5 years were added to a comparison report in order to properly
calculate current assets over total assets, and current asset turnover. Procter & Gamble’s
current assets over total assets ratio increased by 50% over the 5 years of analysis while
the industry average ratio decreased by 23%. Procter and Gamble carries more cash than
any other current asset based on percentage of total assets. The cash and cash equivalents
account increase by 164% from 2010 to 2014. The increase in current assets over time
contributed to the increase of both liquidity ratios. Current asset turnover experienced a
34% decrease from year 2010 to 2014. The increase in Procter & Gamble’s current assets
did not directly result to an increase in sales. The ratio for inventory over total assets
remained steady and decreased only slightly by 6% and falls well below the industry
average. The inventory turnover ratio increases steadily and in the year 2011 matches the
industry average perfectly at 5.92. Property, plant, and equipment as a percentage of total
assets increases by a very small 3% over the 5 years of examination and is much lower
than the average percentage. Property, plant, and equipment turnover decreases by just
over 7% while the industry average practically does not change. Total asset turnover
decreases by less than 2% and is 38% lower than the industry average. The decrease in
turnover for three of the four turnover ratios resulted from the increase in asset accounts.
Compared to the industry averages the lower total asset turnover results could be a cause
from Procter & Gamble being overly invested in its assets. The firm has a large amount
of goodwill reported on its balance sheet from acquisitions of other companies. Goodwill
accounts for 37% of Procter & Gamble’s total assets, which will remain on the balance
sheet until the same acquisitions are sold. This high percentage of goodwill could be the
cause of the low total asset turnover numbers compared to the industry. The firm needs to
increase their sales volume while reinvesting their cash into other assets or redistributing
cash as dividends. Reinvesting their cash into other assets would allow their total assets
to remain unchanged, if sales were to increase this would increase their total asset
turnover. Distributing their cash, as dividends, would also effectively increase total asset
turnover by decreasing total assets. The tradeoff between liquidity and turnover shows

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that as Procter & Gamble increases their assets, effectively increasing liquidity, their
asset turnover decreases.

Leverage and Coverage Ratios


Leverage and Coverage
2014 2013 2012 2011 2010
Procter & Gamble Co. 25.10 24.97 17.28 19.03 16.94
Interest Coverage
Average 35.04 15.70 58.73 29.44 24.42
Procter & Gamble Co. 0.29 0.28 0.33 0.33 0.35
LT Debt to Equity
Average 3.99 3.18 1.37 1.02 4.64
Procter & Gamble Co. 0.51 0.46 0.47 0.47 0.49
Total Debt to Equity
Average 5.06 3.51 1.47 1.11 6.07

The interest coverage ratio for Procter & Gamble increases by 48% from the year 2010 to
2014. A closer look at each individual competitor’s ratios shows that Colgate-Palmolive
had outlier interest coverage numbers. These caused the averages to be skewed positively
except in the year 2013. The only year the firm outperformed the average in interest
coverage was the only year no data was provided for Colgate-Palmolive interest
coverage. The fluctuation of interest coverage is directly correlated to the changes in
operating income and interest expense. Overall, operating income and interest expense
decrease over the 5 years, operating income decreases by 9% and interest expense
decreases by 29%. Since operating income decreases at a slower rate than interest
expense, the firms interest coverage ratio increases. Procter & Gamble has a high interest
coverage ratio, indicating high credit worthiness, but this could also indicate the firm is
under utilizing the benefits of debt. The long-term debt to equity ratio decreases by 17%
over the 5 years of study. Using the common sized financial statements it can be shown
that long-term liabilities decrease by 7% and total equity increases by 14%, this being the
cause for the decrease in the long-term debt to equity ratio. Procter & Gamble has a much
lower long-term debt to equity ratio compared to its competitor’s averages. Consistent
with the other leverage ratio, the firm has a drastically lower total debt-equity ratio
compared to the industry averages. The total debt-equity ratio increases by 4% from 2010
to 2014. This ratio fluctuates as total liabilities and total equity changes, but overall

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increases due to liabilities increasing more than equity. The leverage and coverage ratios
for the industry averages are very volatile, as shown in the table below, each year the
ratio changes substantially. In comparison with Procter & Gamble’s ratio data, its
leverage and coverage ratios are stable. The decrease in long-term liabilities is a
contributing factor to the increase in the interest coverage ratio. As the long-term
liabilities account decreases the interest expense per year decreases causing interest
coverage to increase. After review of the leverage and coverage ratios, the firm is under
utilizing debt that should be readily available to it.

Profitability Ratios
Profitability
2014 2013 2012 2011 2010
Procter & Gamble Co. 48.88 49.59 49.34 50.62 51.96
Gross Margin %
Average 47.00 46.85 46.03 48.60 49.42
Procter & Gamble Co. 18.41 17.21 15.88 19.16 20.30
Operating Margin
Average 17.15 16.71 12.28 15.84 18.36
Procter & Gamble Co. 14.02 13.44 12.85 14.29 16.13
Net Profit Margin
Average 10.94 10.66 6.99 10.13 11.93
Procter & Gamble Co. 8.21 8.33 7.93 8.85 9.68
ROA %
Average 9.85 9.42 6.83 9.68 11.81
Procter & Gamble Co. 16.96 17.20 16.37 18.32 20.51
ROE %
Average 90.18 1760.20 18.19 29.32 30.68
Procter & Gamble Co. 0.59 0.62 0.62 0.62 0.60
Total Asset TO
Average 0.95 0.91 0.89 0.90 1.03
Procter & Gamble Co. 0.51 0.46 0.47 0.47 0.49
Total Debt to Equity
Average 5.06 3.51 1.47 1.11 6.07

Gross margin percentage for Procter & Gamble exceeds the industry average each year of
the ratio analysis. The gross margin percentage decreases each year except 2013 and
decreases a total of 6% from 2010 to 2014. The decrease in gross margin percentage can
be examined on the firm’s financial statements by comparing sales and cost of products
sold. Over the five years sales increase by 5.2% while cost of products sold increases by
6.4%, thus decreasing the gross margin. The operating margin of the firm outperforms

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the average operating margin every year. The operating margin also decreases over time
by 9%. In total operating income decreases by 4.6% while total sales increases by 5.2%
causing the firm’s operating profit margin to decrease. The net profit margin ratio also
decreases over the five years by 13%. Studying the financial statements shows us that net
earnings or net income decreases by 7.4% over the 5 years, again sales increases by 5.2%
resulting in the negative growth of net profit margin. Procter & Gamble’s net profit
margin outperforms the industry average each year. A trend exists between operating
profit margin and net profit margin, each year one ratio increases or decreases the other
does the same. Procter & Gamble outperforms the industry averages with higher margin
percentages, but the higher margins are related to the firm’s low asset turnover. The
return on assets percentage for Procter & Gamble shows a similar trend. The return on
assets percentage decreases by 15% over the 5 years of study. Each year except 2012, the
industry average has a higher return on assets percentage than Procter & Gamble. The
two contributing factors to ROA, profit margin and total asset turnover, show us the
decline of the ratio. Total asset turnover decreases or remains equal each year driving
down the return on assets ratio. ROA increases only one year, caused by an increase of
net profit margin, and total asset turnover remaining constant. Procter & Gamble
outperforms the industry averages for net profit margin but has a lower total asset
turnover than the industry averages causing the firm to have a lower return on assets than
its competitors. The return on equity percentages shows a decline by 17% from 2010 to
2014. The average for return on equity provides very large percentages. In 2013 and 2014
it’s reported that Clorox had a ROE percentage of 10,400 and 372 respectively. This
caused the average to be skewed positively. This is similar to the interest coverage ratios
that were skewed positively by Clorox. The firm’s return on assets and return on equity
share a similar trend that is a decrease from 2010-2012, an increase from 2012-2013, and
a decrease from 2013-2014. Return on assets created the trend, but the changes of the
debt-equity ratio caused return on equity to share a similar trend caused by a separate
factor. The changes of ROA and ROE are driven primarily by the changes in profit
margin.

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Market Value Ratios
Market Value
PE Ratio Market to Book
Procter & Gamble Co. 28.76 3.33
Average 25.86 5.59
Johnson & Johnson 18.78 3.90
Kimberly-Clark Holdings 76.50 56.86
Colgate-Palmolive Co. 23.47 49.65
Ecolab, Inc. 28.34 4.27
Sealed Air Corp. 31.33 7.08
Clorox Co (The) 25.58 130.68
Church & Dwight Co., Inc. 27.63 5.22

Growth Rates % Procter & Gamble Co. Industry 1 Yr. Ago


Long term 8.20 8.23
Dividend - 5 Yr. 7.55 10.30
Sales - 5 Yr. -0.33 9.97
EPS - 5 Yr. -2.46 10.53
Capital Spending - 5 Yr. 4.03 3.31

The price-earnings ratio for Procter & Gamble exceeds the industry average. Procter &
Gamble’s PE ratio is close to the industry average, excluding its outliers. The firm’s PE
ratio indicates that the market expects to pay $28.76 to receive one dollar of its earnings.
A high price-earnings ratio is expected by investors but can be easily inflated by
managers spending excess cash, thus decreasing earnings. The market to book ratio for
PG is lower than the industry average. The ratio still indicates good financial health of the
firm because the market values the firm three times its accounting worth. The Clorox
Company was an outlier and is the major causation for the industry’s average market to
book to be inflated. Even so, Procter & Gamble’s market to book ratio is lower compared
to each individual competitor. Negative growth rates for sales and earnings per share
show that the firm’s earnings are decreasing in correlation with the decrease in expected
sales. The long-term growth rate of Procter & Gamble only decreased by a small
percentage, this small change of 0.3% shows the stability of this growth rate.

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Conclusion
In order to give a proper financial statement analysis, five different groups of financial
ratios were examined to determine the overall financial health of Procter & Gamble. The
firm could use more leverage to finance its assets, debt is cheaper than equity, and the
coverage ratios show that the firm can easily make its interest payments. The liquidity
and turnover ratios show us that the firm’s increase in liquidity caused a decrease in asset
turnover, thus causing the firms return on assets to decrease. With the higher margins of
the firm, in relation to the industry, comes sacrifice of lower total asset turnover ratios.
Declining total asset turnover combined with declining net profit margin consistently
creates the lower than average return on assets for the firm. The data trend between return
on assets and return on equity shows that the firm generates its return from investments
rather than its leverage. The firm should redistribute its cash and cash equivalents back to
its investors as dividends. This adjustment would have several effects on the firm.
Announcing an increase in dividends would increase the dividend growth rate, thus
increasing the stock price and the price earnings ratio. The use of the cash as dividends
would result in an increase in total asset turnover, causing an increase in ROA and ROE.
These results could strengthen the overall financial health of the firm and maximize
shareholder wealth.

Cost of Capital
Introduction
The weighted average cost of capital is an estimate of the required return that is
demanded by a firm’s debt and equity holders. It proportionately estimates the cost of
debt and equity of a firm. For this analysis of Procter & Gamble the WACC is calculated
using the firm’s weights of debt and equity, and the required returns for debt and equity.
The weighted average cost of capital formula includes the percentage weight and required
return for preferred stock. The preferred stock of Procter & Gamble has been excluded
from the estimation of the WACC. It was excluded from this calculation because the
amount of preferred stock, provided by Morningstar, was estimated to be about 1%. This
small amount of preferred stock would cause an immaterial change in the calculation of

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the WACC, thus it was excluded altogether. In the subsequent paragraphs lie
explanations of the calculations and estimations of the weights and required returns of
debt and equity that lead to the estimated cost of capital.

Cost of Debt
To begin the discussion of the cost of capital, the cost of debt will be analyzed and
discussed. The two methods chosen to estimate the cost of debt for Procter & Gamble
were the credit rating method and the synthetic rating method. An assumption of a risk-
free rate is required for both methods used. The 10-year US Treasury Bond rate is used in
the following estimations. The 10-year T-bond rate of 1.93% is being used from the
website Yahoo Finance and the data was taken February 1, 2016. The 10-year US
Treasury bond is the most ideal risk-free rate because Procter & Gamble is domestic to
the United States and uses the United States dollar as its local currency. Also, an estimate
of the length of the firm’s projects cannot be made accurately enough to choose a security
with a shorter or longer time horizon, thus the 10-year T-bond is the most logical choice
for this valuation because it represents the average project length. The 10-year US
Treasury bond rate is also used because it satisfies criteria for choosing a risk-free rate
that were established by Dr. Damodaran in his text, Applied Corporate Finance (Pg. 88).
His criteria state that a risk-free rate must be default risk-free and it must be free of
reinvestment risk. A government bond is considered to be default risk-free if the
government has a credit rating of Aaa, the United States debt is rated Aaa and is
considered to be default risk-free. The 10-year US T-bond rate is not free of reinvestment
risk because the coupons on the bond can be reinvested in the future at unknown rates,
but an assumption is made that the present value of these changes in the rates is
immaterial because the difference between the short and long term rates is small. For the
credit rating method, the credit rating used, AA, was provided by the website
Morningstar, located under the Procter & Gamble bond information. Using Dr.
Damodaran's Ratings, Interest Coverage Ratios, and Default Spreads table, from his
website, the default spread for an AA rating is 1.00%. This spread plus the 10-year US
Treasury bond rate is the estimated cost of debt, 2.93%. To estimate the cost of debt
using the synthetic rating method, data from PG's 2014 10k was required. This data

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consisted of the operating income and interest expense for 2014, as well as the operating
leases data. The synthetic rating adjusts the times interest earned, or interest coverage,
ratio for the operating leases of a firm in order to provide a rating. It reclassifies the
operating leases as debt, which provides for a more accurate representation of the cost of
debt. Prior to adjusting for the firm’s operating leases Dr. Damodaran’s Ratings sheet
provided a rating of AAA. After adjusting for the operating leases, Damodaran's Ratings
sheet maintained the AAA rating, with an estimated default spread of 0.75%. Adding this
to the risk-free rate, 1.93%, an estimated cost of debt of 2.68% was found. Addition of
the operating leases only increased the interest coverage ratio, used for calculation of the
synthetic rating, by a small percentage, thus it did not affect the default spread and
estimated cost of debt. The two methods for estimating cost of debt provided for similar
results. Both methods provided for a low default spread, Procter & Gamble's high interest
coverage ratio resulted in the lowest possible spread. The results show that Procter and
Gamble is highly credit worthy and that the company has a low cost of debt compared to
the household products industry cost of debt, 4.02%, provided on Dr. Damodaran’s Cost
of Capital by US Sector webpage.

Market Values of Debt and Equity


Next, the explanation of the estimated market values and weights of debt and equity used
for the weighted average cost of capital computation. The percentage weight of equity is
simply calculated by dividing the estimated market value of equity by the sum of the
estimated market value of equity and the estimated market value of debt. The estimated
market value of equity for Procter & Gamble is calculated by multiplying the stock price
and the number of shares outstanding. The common stock price of $76.51 was provided
as the price on January 12th, 2016 from Mergent Online. The number of shares
outstanding 2,720,572,743 was used from the capital stock information downloaded from
Mergent Online, and represents the number of shares currently outstanding as of
September 30th, 2015. Using this data the market value of equity can be estimated as
$208,151,020,566.93. The estimated market value of debt for Procter & Gamble was
calculated using four variables: total liabilities, interest expense, estimated cost of debt,
and the weighted average of the bonds time to maturity dates. In order to make the best

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estimate of the market value of debt these four variables are used in the time value of
money equation to find the present value of liabilities. The total liabilities used in this
estimation was taken from the 2014 balance sheet, the interest expense was taken from
the 2014 income statement, both financial statements derived from Mergent Online. The
estimated cost of debt, 2.68%, is shown previously calculated in the above section using
the synthetic method. It is used as the required return in this TVM estimation. The
weighted average of the time to maturity dates, for the bonds held by Procter & Gamble,
provides an estimated average number of periods for the present value equation. The data
used for this calculation was taken from Procter & Gamble’s 2014 10k. The net present
value of all the operating leases was calculated and added to the present value of
liabilities, resulting in the estimated market value of debt, $66,756,809,307.28. Based on
the estimated market value of debt and equity, Procter & Gamble’s current capital
structure is 76% equity to 24% debt.

Cost of Equity
The cost of equity is the rate of return that is required by investors to invest in the equity
of the firm. (Damodaran Pg. 88) The capital asset pricing model is the model that was
used for the calculation of Procter & Gamble’s cost of equity. The CAPM was used
instead of the arbitrage pricing model or the multifactor model because it is most
commonly used by analysts and is the simplest method for estimating the cost of equity.
The capital asset pricing model is dependent on three variables: beta, risk-free rate, and
market risk premium. Two methods were used to estimate the beta required in the CAPM
equation, a regression beta and a bottom up beta. The risk-free rates, shown above under
the cost of debt section, will be used again in the CAPM estimation. The implied risk
premium and historical risk premium are the market risk premium methods used in this
estimation.
Regression Beta:
The CAPM equation that applies to the method used in estimating this regression beta is
in terms of raw returns. The CAPM raw return equation, 𝑅𝑗 = 𝛼 + 𝛽𝑗 𝑅𝑚 , and the raw
returns, earned by Procter & Gamble and the S&P 500 index from the past 5 years, were
used in the estimation of this regression beta. Regression of the raw returns of Procter &

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Gamble against the raw returns of the S&P 500 index provides the regression beta. The
proportion of Procter & Gamble’s risk attributable to market risk, shown by Microsoft
Excel as R2, is estimated being 18.19%. The proportion of firm-specific risk (1 – R2) is
estimated being 81.81%. The length of the estimation period offers a trade-off, a longer
estimation period provides more data, but the firm itself might have changed in its risk
characteristics over the time period. Procter & Gamble is the largest company in its
industry and seems to have not changed its business structure or leverage policies
recently, and with the financial stability of this firm a longer estimation period could be
used to provide a more accurate regression. There is advantage to using monthly returns
rather than daily returns that arises with the non-trading bias and the bid-ask bounce.
During a non-trading period of a firm, if there is still movement in the market for those
periods this creates a bias, which reduces the firm’s beta. The non-trading bias can be
reduced significantly by using monthly returns of a firm. Although Procter & Gamble
would most likely not be subject to this bias with its large trading volume, it could be
subject to daily changes occurring from the changes in the bid-ask spread. The bid-ask
bounce is also reduced with the use of monthly returns. According to Dr. Damodaran, the
index used to estimate the beta for the capital asset-pricing model should be the market
portfolio that includes all traded assets in the market, held in proportion to their market
values. The S&P 500 index gives the best representation of the market portfolio, it is a
broad index of 500 companies, and the stocks are held in proportion to their market
values. The S&P 500 index represents the market the best for the estimation of Procter &
Gamble’s beta because it is a domestic U.S. company, and it satisfies the two criteria that
should be met for use in regression analysis. The beta provided from the regression
model equaled 0.48, with a standard error for this beta estimate of 0.13. The standard
error of the estimate suggests that the regression beta of Procter & Gamble could range
from 0.35 to 0.62 with 67% confidence, 0.22 to 0.75 with 95% confidence, and 0.08 to
0.89 with 99% confidence. This shows us that the beta for the regression model could be
highly inaccurate with such a range from 0.08 to 0.89.
Bottom Up Beta:
A bottom up beta is an estimation process to find the levered beta of a firm. It uses a
weighted average of individual firm’s regression betas within an industry. An adjustment

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is made to the average by removing the financial leverage of the industry, which causes
the beta to be positively inflated. The removal of any cash holdings, which have a beta
close to zero, leaves the raw beta that is the unlevered beta corrected for cash. This
number represents the pure business risk of that industry. This figure can then be used in
estimation for the beta of an individual firm. The cash holdings and financial leverage are
combined with the unlevered cash adjusted beta, resulting in the bottom up or levered
beta for the firm. Procter and Gamble is primarily in one industry, household products,
therefore a weighted average of different industry betas is not necessary. The unlevered
beta corrected for cash, 0.91, is provided on Dr. Damodaran’s website under the Levered
and Unlevered Betas by Industry webpage. The cash holdings from the 2014 balance
sheet, downloaded from Mergent Online, were divided by the market value of equity.
This value was then multiplied against the unlevered beta corrected for cash to equal the
unlevered asset beta, 0.87. The debt to equity ratio, calculated by dividing the market
value of debt by the market value of equity, is used to add leverage back into the beta.
The debt to equity ratio is adjusted for the marginal tax rate, 33.12%, which is the
average tax rate for money-making companies in the household products industry,
information used from Dr. Damodaran’s website, found on the Tax Rates by Sector table.
The product of the unlevered asset beta and the tax adjusted debt ratio produce Procter &
Gamble’s bottom up beta, or their equity levered beta. This estimation process provided
for a bottom up beta of 1.06, much higher than the estimated regression beta. The main
advantage to using a bottom up beta instead of a regression beta is the substantial
reduction in the standard of error. The standard error, 0.13, for the regression beta creates
a wide range of error that makes it unreliable. The regression beta estimated for Procter
and Gamble had a range from 0.08 to 0.89 at the third standard deviation. Dr. Damodaran
states in his text, Applied Corporate Finance, the bottom up beta is an average of many
firms regression beta and that the standard error is greatly reduced using a bottom up
beta. An example shows that the standard error of a regression beta is reduced from 0.25
to 0.025, when the average of 100 firms is used. The number of firms in the household
products industry, 134, greatly reduces the standard error of the bottom up beta.
Market Risk Premium:

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The historical market risk premium is the average of the risk premiums over a time
period. Three choices must be made when using historical data to estimate the equity risk
premium: time period used, risk-free security, and the choice of using the arithmetic
averages versus geometric averages. The option to adjust the historical risk premium
based on these factors provides flexibility for the CAPM estimation. For this analysis the
historical risk premium chosen uses the geometric average, 10-year US T-bond rate, and
the longest time horizon available. The geometric average provides a better estimate of
long run return compared to the arithmetic average. The risk premium that uses the 10-
year T-bond rate is used because it is the long-term security consistent with the typical
project length for long-term investments. The longest time period available, 1928 to
2015, provides less standard error compared to the short-term time periods. The historical
risk premium that meets these criteria is 4.54%, this information was used from Dr.
Damodaran’s website and is be located at the bottom of the Historical Returns on Stocks,
Bonds, and Bills webpage. The implied risk premium model, similar to the dividend
growth model, is estimated using with the current market index, the expected dividends,
and the expected growth rate of earnings.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑛𝑒𝑥𝑡 𝑝𝑒𝑟𝑖𝑜𝑑
(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐼𝑛𝑑𝑒𝑥 𝑃𝑟𝑖𝑐𝑒 = ) − 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 = 𝐼𝑅𝑃
(𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠)

The above equation, that can be found in Dr. Damodaran’s text Applied Corporate
Finance, is the model for the implied risk premium. After the addition of the above
inputs, the required return on equity can be solved for. Subtracting the risk free rate from
the required return results in the implied risk premium. Dr. Damodaran provided on
February 1, 2016 an implied risk premium of 5.61% at the bottom of his website’s
homepage. This implied risk premium is used in the estimation of the cost of equity.
Capital Asset Pricing Model:
The capital asset pricing model is a function of a firm’s beta, risk-free rate, and market
risk premium. Shown below is a cost of equity sensitivity analysis with changes in the
cost of equity resulting from changes in the beta, risk-free rate, or market risk premium.
The implied risk premium is used over the historical risk premium because it better
reflects the risk premium that would be demanded by an investor in current market
conditions.

15
Cost of Equity Sensitivity Analysis
Estimates Beta Risk-free Risk Premium Cost of Equity
Base Case: Bottom Up, IRP, 10 Yr. 1.05974955 1.93% 5.61% 7.88%
Change 1: Regression Beta 0.48491809 1.93% 5.61% 4.65%
Change 2: Historical Risk Premium 1.05974955 1.93% 4.54% 6.74%
Change 3: 5 Yr. T-bond Rate 1.05974955 1.35% 6.80% 8.56%

The base case cost of equity includes the bottom up beta, implied risk premium, and 10-
year T-bond rate. The base case, or best estimate, results an estimated cost of equity of
7.88%, shown underlined above. The bottom up beta is used in the capital asset pricing
model because it provides a beta that has significantly less standard error compared to the
estimated regression beta. Using the regression beta, shown in change 1 of the table,
decreases the cost of equity by 41%. Such a lower cost of equity could in turn allow
managers to approve projects that could actually have a negative net present value. The
second change in the table shows the use of the historical risk premium, the cost of equity
decreases as expected with the decrease in the risk premium percentage. The third change
in the sensitivity analysis shows the use of the 5-year Treasury bond rate 1.35%. The risk
premium had to be adjusted for this change as well because the implied risk premium is a
function of the risk-free rate. The implied risk premium calculator provided by Dr.
Damodaran “spreadsheet to compute current ERP for current month” on his websites
homepage was used to calculate the risk premium using the 5-year Treasury bond rate
and the current index. An assumption is made that Procter & Gamble has projects that
average at or greater than 10 years, this being the ultimate reason the 10-year T-bond rate
is used as the risk free rate instead of the 5-year T-bond rate.

Weighted Average Cost of Capital


The weighted average cost of capital is an estimate of the required return demanded by a
firm’s debt and equity holders. The weighted average cost of capital requires the weights
and required returns of debt and equity. As previously mentioned the weight and required

16
return of preferred stock was omitted from this estimation. In the table provided below is
a sensitivity analysis of the weighted average cost of capital for Procter and Gamble.

Weighted Average Cost of Capital: Sensitivity Analysis


Estimates %E Re %D Rd (1-t) WACC
Base Case: Cost of Equity Base, Synthetic Rating 75.72 7.88 24.28 2.68 66.88 6.40%
Change 1: Cost of Equity Base, Credit Rating 76.04 7.88 24.28 2.93 66.88 6.46%
Change 2: Cost of Equity Chg. 1, Synthetic Rating 75.72 4.65 24.28 2.68 66.88 3.96%
Change 3: Cost of Equity Chg. 2, Synthetic Rating 75.72 6.74 24.28 2.68 66.88 5.54%
Change 4: Cost of Equity Chg. 3, Synthetic Rating 75.72 8.56 24.28 2.68 66.88 6.91%
Change 5: Cost of Equity Chg. 1, Credit Rating 76.04 4.65 23.96 2.93 66.88 4.01%
Change 6: Cost of Equity Chg. 2, Credit Rating 76.04 6.74 23.96 2.93 66.88 5.60%
Change 7: Cost of Equity Chg. 3, Credit Rating 76.04 8.56 23.96 2.93 66.88 6.98%

The best case weighted average cost of capital consists of the percentage debt and equity
based on market values, the best case cost of equity using the capital asset pricing model,
and cost of debt estimating using the synthetic rating method. The tax rate, 33.12%, used
in the WACC estimation is being used again to maintain consistency and remains
unchanged through out the sensitivity analysis. It is the marginal tax rate for money-
making companies within the household products industry. A total of seven changes were
conducted to the base case to create several different outcomes. The first change is only a
change from the synthetic rating to the credit rating, but affects the cost of debt and the
proportionate weights of debt to equity. Changing the method from synthetic to credit
rating increases the cost of debt, thus increasing the WACC for each scenario. The
percentage of total debt decreases whenever this change occurs because the estimation of
the market value of debt is reliant on the estimated cost of debt. Increasing the cost of
debt resulted in a decrease in the estimated market value of debt, thus decreasing the
percentage of debt in relation to the equity. Each change made in the cost of equity
sensitivity analysis was included to show the direct change in the WACC from changes in
the cost of equity. The synthetic rating provides the best estimate of the cost of debt
because it includes operating leases. As previously mentioned the best estimate of the
cost of equity uses the bottom up beta, implied risk premium, and the 10-year Treasury

17
bond rate. This best estimate of the cost of equity and the synthetic rating provide the best
estimate of the weighted average cost of capital at 6.40%. The WACC estimations are
within a reasonable range of 5.54% to 6.98%.

Optimal Capital Structure


Introduction
The optimal capital structure of a firm represents the best estimate of a capital structure
that a firm can use based on its environment. For this analysis of Procter & Gamble the
optimal capital structure was estimated using the cost of capital approach, in contrast to
using the adjusted present value approach or operating income approach. The cost of
capital approach was used to find the optimal capital structure because the inputs that are
used in estimation have already been previously calculated in this analysis. Also, this
approach allows for sensitivity analysis to determine the optimal capital structure with the
lowest weighted average cost of capital. Dr. Damodaran states in his text, Applied
Corporate Finance, by altering the weights of debt and equity in the weighted average
cost of capital equation, a firm might be able to change their cost of capital. As
previously mentioned, the preferred stock of Procter & Gamble was excluded from this
analysis due to its small effect on the overall analysis. The table shown below illustrates
the process and information used for this estimation. The subsequent paragraphs will
describe the detailed steps taken in finding the optimal capital structure for Procter &
Gamble.

Debt Cost of
We Beta Value of Debt Interest Expense TIE Spread Cost of Debt WACC
Ratio Equity
0% 100% 0.87 6.83 - - - 0.75 2.68 6.83
10% 90% 0.94 7.19 27,490,782,987 736,752,984 20.751 0.75 2.68 6.65
20% 80% 1.02 7.64 54,981,565,975 1,473,505,968 10.375 0.75 2.68 6.47
30% 70% 1.12 8.23 82,472,348,962 2,498,912,174 6.118 1.10 3.03 6.37
40% 60% 1.26 9.01 109,963,131,950 3,496,827,596 4.372 1.25 3.18 6.26
50% 50% 1.46 10.10 137,453,914,937 5,058,304,070 3.022 1.75 3.68 6.28
60% 40% 1.75 11.74 164,944,697,925 18,028,455,483 0.848 9.00 10.93 9.08
70% 30% 2.23 14.46 192,435,480,912 34,503,681,728 0.443 16.00 17.93 12.73

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80% 20% 3.21 19.92 219,926,263,899 39,432,779,117 0.388 16.00 17.93 13.58
90% 10% 6.12 36.29 247,417,046,887 44,361,876,507 0.345 16.00 17.93 14.42
100% 0% - - 274,907,829,874 49,290,973,896 0.310 16.00 17.93 -

The cost of capital approach is an estimation of a firm’s cost of capital using different
weights of debt and equity. The different weights of debt and equity are estimated by
adjusting the debt ratio, for this estimation the debt ratio scales from zero to one hundred
percent in intervals of ten percent. With every change of the debt ratio an accompanied
change is made to the other inputs of the cost of capital equation. The variables that do
not vary with variations in the weights are the tax rate, risk free rate, implied risk
premium, operating income, and market value of the firm. The inputs, excluding the
weights, are shown in the table below and are from the previous cost of capital estimation
and the 2014 financial statements.

Market Value of Debt 66,756,809,307 Total Liabilities (2014) 74,290,000,000


Market Value of Equity 208,151,020,567 Interest Expense (2014) 709,000,000
Current Firm Value (Debt+Equity) 274,907,829,874 Interest Coverage Ratio 21.56276446
Current Debt Ratio (MVd/MVf) 24.28% Current Cost of Equity 7.88%
Tax Rate 33.12% Default Spread 0.75%
Levered Equity Beta 1.06 Current Cost of Debt 2.68%
Risk Free Rate 1.93% Weight Equity 0.76
Implied Risk Premium 5.61% Weight Debt 0.24
Operating Income (2014) 15,288,000,000 Current WACC 6.40%

Following the weights of debt is the accompanying percentage weights of equity. These
weights were calculated by subtracting the corresponding debt weight by 1, rationally 0%
debt is equal to 100% equity. The next estimated component of the cost of capital
equation is the beta. The bottom up beta previously estimated and used as part of the base
case for the WACC is used for this approach. The levered equity beta, 1.06, must be
adjusted to become unlevered beta, which is the starting point at 0% debt. Removing the
tax-adjusted market value of debt to equity ratio results in an unlevered beta of 0.87. To
find each new beta the corresponding tax-adjusted debt to equity ratio is added back. The
beta must be adjusted for each new debt ratio, as the debt ratio increases, risk also

19
increases, thus increasing the beta. The new cost of equity is the product of the implied
risk premium and the new beta plus the risk free rate. The implied risk premium, from
Dr. Damodaran’s webpage, and the risk free rate, 10-year U.S Treasury bond rate from
Yahoo Finance on 02/01/16, are constant variables. As the debt ratio and beta increase,
the cost of equity increases at an increasing rate until the estimation is using 100% debt.

The total market value of the firm is held constant for the cost of capital approach to add
simplicity to the estimation. The total market value of the firm does not increase, the
market value of debt increases but for each increasing debt ratio an assumption is made
that debt is used to buy back the firm’s stock. At each new market value of debt a
corresponding interest expense is calculated by multiplying it by the cost of debt. Next
the times earned interest ratio is calculated by dividing the operating income, from the
2014 income statement, by the corresponding interest expense. The synthetic rating
method is used to estimate the default spread using Dr. Damodaran’s Rating, Interest
Coverage Ratio, and Default Spread table from his website. The estimated interest
coverage ratio falls into an interval that is used to determine the default spread for each
debt ratio. The default spread plus the risk-free rate equals the new cost of debt. The
initial cost of debt consists of the risk-free rate and the lowest spread, theoretically since
the firm would have no debt the cost of debt would be zero. The interest coverage ratio is
reliant on the previous cost debt estimation, implicitly the previous default spread since
the risk-free rate is constant. Thus, an assumption is made that the initial debt ratio of 0%
still has a cost of debt of 2.68%. This begins a cyclical process between the market value
of debt, interest coverage ratio, default spread, and cost of debt. The cost of debt for the
previous debt ratio is used with the new market value of debt to estimate a new interest
expense, which is then used to compute a new interest coverage ratio that could fall in
between a new interest coverage interval changing the default spread, resulting in a new
cost of debt. The cyclical process continued for each debt ratio and the spread increased
each time the interest coverage decreased enough. As the debt ratio increased, naturally
the market value of debt correspondingly increased as well as the interest expense. Each
increase in interest expense decreased the interest coverage ratio because the operating
income is assumed to be constant. The steady decrease in the interest coverage ratio

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caused an increase in the default spread up to 16%, almost the data table’s limit of 20%.
The changes in the debt ratio caused a range of the cost of debt from 2.68% to 17.93%.
After the new cost of debt was found for each debt ratio an adjustment was made to the
interest expense computation that used the corresponding cost of debt. This adjustment
created another cyclical process changing the interest coverage ratio, default spread, cost
of debt, and interest expense until the interest coverage ratio stabilized with a credit
rating.

After the previous adjustment was made to correct the cyclical estimation process, the
new weighted average cost of capital was estimated for each debt ratio and its respective
inputs. The lowest estimated weighted average cost of capital, 6.26%, is the cost of
capital that maximizes the firm value. The lowest WACC produces the highest net
present value of future cash flows, thus maximizing the firm’s value. The estimated
WACC of 6.26%, highlighted in the table above, indicates the optimal capital structure
that the firm should use, 40% debt and 60% equity.

A sensitivity analysis was performed for the cost of capital approach in order to provide
additional estimations using different variables. The bottom up beta was initially used as
the base case for the estimation. For the sensitivity analysis, the regression beta
previously computed at 0.48 with 0.13 standard error was unlevered and then re-levered
at each debt ratio. Naturally, this smaller beta decreased the cost of equity and weighted
average cost of capital for each debt ratio. The decrease in both the cost of equity and
WACC was proportionate with the change in beta. Therefore the estimated optimal
capital structure did not change, the cost of capital approach using the regression beta
provided a capital structure of 40% debt and 60% equity. The second variable that was
changed for the sensitivity analysis was the tax rate used for the estimation. The tax rate,
33.12%, used for the initial estimation was one that was used for the previous cost of
capital estimation. On Dr. Damodaran’s website from the Tax Rates by Sector table, it is
the average tax rate for only money making companies in the household products
industry. The tax rate used for the sensitivity analysis is from Procter & Gamble’s 10k
under the income taxes section. For 2014 the effective tax rate for Procter & Gamble was

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21.40%. Using the smaller tax rate increased the cost of capital for each debt ratio. Unlike
the changes in the cost of capital caused by using the regression beta, the changes in the
cost of capital caused by substituting the tax rate are not proportionate. Reducing the tax
rate reduces the tax-deductible benefit of using debt. In this case, decreasing the tax rate
from 33.12% to 21.40% is not a significant enough decrease to alter the estimated
optimal capital structure. The cost of capital approach using the tax rate from Procter &
Gamble’s 10k estimated an optimal capital structure of 40% debt and 60% equity. To
illustrate the changes caused by adjusting the tax rate, the rate of 20.80% was used in
place of 21.40%. This small change resulted in two optimal capital structures with debt
ratios of 20% and 40%, each having the lowest estimated cost of capital of 6.512%. This
shows that using a reduced tax rate devalues the use of debt, thus reducing the debt ratio
for the cost of capital approach.

To further the capital structure analysis and to find a more precise optimal capital
structure the process was recomputed. The estimations were found using an increasing
debt ratio in intervals of one percent. Using an interval of one percent provides a more
accurate representation of the optimal capital structure. To accelerate the iterative process
Excel’s vLookup function was used with Dr. Damodaran’s Rating, Interest Coverage
Ratio, and Default Spread table. Allowing excel to perform iterative processes automated
the estimation of all 101 weighted average cost of capital values. The estimated optimal
capital structure with the lowest weighted average cost of capital was 59% equity and
41% debt, very similar to the original estimation. A sensitivity analysis was then
performed again using the regression beta, and tax rate from Procter & Gamble’s 10k as
the changing variables. As expected, changing the beta proportionately changed the
lowest WACC, maintaining the optimal capital structure of 59% equity and 41%. Using
the tax rate from Procter & Gamble’s 10k, and decreasing the rate from 33.12% to
21.40% resulted in a remarkable change. The optimal capital structure changed to 76%
equity and 24% debt, which is the current capital structure of Procter & Gamble
estimated previously with the market values of debt and equity.

Conclusion

22
The first estimations show that the optimal capital structure for Procter & Gamble is 40%
debt and 60% equity. The capital structure that was computed using the current market
values of debt and equity of Procter & Gamble suggested the use of 76% equity and 24%
debt. After adjusting the debt ratio to increase in intervals of one percent and using the
tax rate from the firm’s 10k, the optimal capital structure was an exact match to the
firm’s current capital structure. The tax-benefit the firm could receive from increased
debt financing could be less valuable than maintaining a high credit rating. The credit
rating of AA and AAA, provided by Morningstar and estimated using the synthetic rating
method, respectively, are high credit ratings. The firm’s reputation and access to
commercial paper markets may be more essential than a slightly lower WACC. Based on
the estimation of the optimal capital structure, using the firm’s 10k tax rate, it can be
concluded that Procter & Gamble is using a capital structure that is optimal.

Dividend Policy
Cash Return Ratio
The dividend policy of Procter & Gamble is straightforward, continuously return earnings
to investors through dividends and stock repurchases. The following dividend policy
analysis explains the methods and comparisons used to deduce the aforementioned
statement. An estimated free cash flow to equity (FCFE) provides the dollar amount that
is available to be paid to shareholders, as dividends or stock repurchases. The net cash
flow to shareholders is the actual dollar amount that was paid out to shareholders in
dividends and stock repurchases. Comparing these amounts provides a valuable financial
ratio, the cash returned ratio, which is the net cash flows to shareholders divided by the
free cash flows to equity. If the cash return ratio was equal to one this would indicate that
a firm is paying its shareholders the exact amount that is has available as free cash flows.
Simply, this ratio indicates if a firm is paying out more or less than it can as dividends.

The free cash flow to equity is estimated as the sum of net income, depreciation &
amortization, changes in current asset & liability accounts, capital expenditures, proceeds
from asset sales, acquisitions, and changes in debt, less any dividends paid to preferred
shareholders. The values used in the estimation of each FCFE, with exception of

23
preferred dividends, were taken from Procter & Gamble’s statement of cash flows for the
years ranging 2010 to 2014. The amount of preferred dividends paid to shareholders each
year was taken from the firm’s income statement. Procter & Gamble’s financial
statements used in this analysis were downloaded from Mergent Online, and were
previously used in the analysis of this firm. Any investment activities listed on Procter &
Gamble’s statement of cash flows were excluded from the FCFE estimation because
these investments are short-term cash holdings of the firm. The net cash flows to
shareholders is the estimated total of stock dividends and treasury stock repurchases, both
amounts found on Procter & Gamble’s statement of cash flows.

Procter & Gamble's cash returned ratio, in total, decreases over the five years of study.
The cash returned ratios greater than one, 2010 to 2012, indicate that Procter & Gamble
is paying out more to its investors in dividends and stock repurchases than it had
available as free cash flows. The ratios less than one show that the firm is paying less to
shareholders and retaining the free cash flows as cash. Increasingly each year the firm has
paid out more dividends to its shareholders, a total increase on the statement of cash
flows of 26.62% from 2010 to 2014. Procter & Gamble's net cash flows to shareholders
are not accurately represented by the increase in dividends paid. This is the result of the
volatile changes in the total amount of stock repurchases each year, which is directly
correlated to the fluctuating changes in net income. Examining the statement of cash
flows shows that the firm retains more cash in years that net income decreases, and
reduces the amount of stock repurchases that it makes. The cash return ratio ranges from
0.937 to 1.210, and has a median of 1.010 over the five years. This suggests that Procter
& Gamble is paying most of its available free cash flows back to its shareholders through
dividends and stock repurchases. The years 2010 through 2012 provide a cash return ratio
greater than one, meaning Procter & Gamble paid out more dividends and stock
repurchases than the estimated available free cash flow. The table below illustrates the
cash return ratio and return ratios that will be discussed next.

24
Financial Accounting Ratios
(Reported in Millions) 2014 2013 2012 2011 2010
FCFE $13,784 $12,614 $10,065 $10,585 $11,096
Net Cash Flows to Shareholders $12,916 $12,505 $10,163 $12,806 $11,462
Cash Returned Ratio 0.937 0.991 1.010 1.210 1.033
Return On Assets 8.17% 8.19% 8.25% 8.53% 9.94%
Return On Capital 8.89% 8.05% 7.64% 9.26% 9.54%
Return On Equity 16.84% 16.59% 17.03% 17.35% 20.73%
Cost of Equity 7.88%
Cost of Capital 6.40%
Return Spread (ROC - Cost of Capital) 2.49% 1.65% 1.24% 2.86% 3.14%
Equity Return Spread (ROE - Cost of Equity) 8.97% 8.72% 9.15% 9.47% 12.85%

Financial Accounting Returns


Accounting returns were estimated for each year using the firm’s financial statements,
including the return on assets, return on invested capital, and return on equity. The return
on assets ratio, net income over total assets, decreases by a total of about 18% from 2010
to 2014 corresponding to the total decreases in net income and increases in total assets.
The return on invested capital ratio, operating income net of taxes over assets net of cash,
was then computed. Cash is removed from assets to reflect only the invested capital in
order to be consistent with the numerator, operating income. These percentages were then
compared to the cost of capital, previously estimated as the WACC. The difference
between the ROIC and the cost of capital provides the return spread.

Procter & Gamble’s return on equity ratio consistently provides higher percentages
relative to the other return ratios. This high return on equity ratio could be caused by the
use of the book value of equity. In 2014 Procter & Gamble’s balance sheet reports total
shareholder’s equity at roughly $70 billion. The market value of equity previously
estimated for this analysis totaled approximately $208 billion. This large difference in the

25
book value of equity and market value of equity creates an illusion that Procter &
Gamble’s real return on equity should be much closer to it’s estimated cost of equity. In
the article, Return on Capital, Return on Invested Capital, and Return on Equity:
Measurement and Implications, written by Dr. Aswath Damodaran, it states that the
market value of equity is inappropriate to use for the return on invested capital and return
on equity computations. He provides two rationales to support this, computing
accounting returns using the market value of equity would create a downward bias of the
returns because market values include growth and expectations for the future. And, the
market value marks up the value of existing assets to reflect their earning power, where if
there were no growth assets the market value would generate a return on capital equal to
the cost of capital. An assumption is made that computing the return on equity using the
book value of equity is effective for comparison to the cost of equity. The positive capital
and equity excess returns for Procter & Gamble show that the firm is investing in
profitable projects.

In Dr. Damodaran’s article, Return on Capital, Return on Invested Capital, and Return
on Equity: Measurement and Implications, he provides a theory that can explain Procter
& Gamble’s high return on equity, relative to its return on capital. He explains that when
a firm uses cash to pay dividends or buy back stock, it reduces its book value of equity by
the amount of the dividend or stock repurchase. This could decrease the firm’s net
income, if the cash used to pay the dividend or buy back stock generated income in prior
periods. The return on equity increases as the book value of equity decreases out of
proportion to net income. The return on invested capital is not affected by the use of cash
for dividends or stock repurchases because it only considers the invested capital and
operating income. Procter & Gamble is in the mature stage of its life cycle and has a high
dividend payout ratio, 40.49% provided by Reuters.com. The firm’s large dividend
payouts and stock repurchases, along with its historic use of cash to pay dividends and
repurchase stock above the estimated cash flow to equity, explains the firm’s inflated
return on equity. Procter & Gamble’s cost of equity, previously estimated in the cost of
capital section of this analysis, is compared to the return on equity providing the return on
equity spread.

26
Dr. Damodaran provides reasoning that can explain Procter & Gamble’s low return
spread. He states that there is a scale effect on return on capital, as the size of a firm
increases the return on invested capital decreases and firms with the largest amounts of
invested capital have the lowest returns. Illustrated below is a histogram, provided in Dr.
Damodaran’s article, Return on Capital, Return on Invested Capital, and Return on
Equity: Measurement and Implications, which shows the inverse correlation between
return on invested capital and invested capital. Procter & Gamble’s invested capital was
estimated to be about $136 billion. Comparing this value to the table below shows that
Procter & Gamble is a mature firm with a large amount of invested capital, which
explains the positive yet low return on invested capital.

Stock Returns
Accounting returns are useful but can be inconsistent and unreliable, thus stock returns
for Procter & Gamble were estimated to provide additional perspective. The common
stock return and dividend yield were computed for the same time horizon, 2010 to 2014
in order to maintain data consistency. The stock prices, used for this stock return
calculation, were taken from Morningstar on 03/29/16 and represent the fiscal year end
closing prices. The dividends paid per share were taken from the firm’s reported income
statements, information downloaded from Mergent Online.

27
Common Stock Returns
2010 2011 2012 2013 2014 Average Return
Price $64.33 $66.71 $67.89 $81.41 $91.09
Dividend $1.80 $1.97 $2.14 $2.29 $2.45

Return 6.76% 4.98% 23.29% 14.90% 12.48%


Div. Yield 2.80% 2.95% 3.15% 2.81% 2.69% 2.88%
Div. Yield Corrected 3.06% 3.21% 3.37% 3.01% 3.16%
Annualized Return 7.20%
Total return 10.37%

The stock return of a firm is the percentage change in stock price, it was estimated above
as the current stock price plus current dividend minus the previous year stock price
divided by the previous year stock price. The arithmetic average was then found for the
four stock returns that estimated to be 12.48%. This average stock return can be
compared to the cost of equity, 7.88%, used previously in this section. The average stock
return represents the percentage return a shareholder earned, while the cost of equity
represents the return that a shareholder demands from the firm. Comparing the average
return and cost of equity provides a spread of 4.60%. This percentage is the excess return
that a shareholder received for investing in Procter & Gamble. The dividend yield was
measured first as the current year dividend over the current year stock price. This method
was not accurate for this analysis an adjustment was made to correct the dividend yield
that used the current period dividend over the previous period stock price. An average
was then found for the four estimated dividend yields, it being 3.16%. Using the time
value of money equation, the annualized rate of return was computed using the 2010 and
2014 stock prices. This return, 7.20%, plus the corrected average dividend yield, 3.16%,
provided an estimated total return of 10.37%. The estimated total return, 10.37%,
compared to the cost of equity, 7.88%, provided an excess return to Procter & Gamble
shareholders of 2.49%. Both estimated stock returns provided excess returns in contrast
to the cost of equity, thus Procter & Gamble is creating profitable returns on the projects
it invests in.
Conclusion

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Procter & Gamble’s high payout ratio, 40.49%, and average dividend yield, 3.16%, are
consistent with its stage as a mature growth firm. It has the ability to make consistent
large dividend payouts to its shareholders, while also making stock repurchases with its
free cash flows. The estimated cash returned ratio is maintained close to one from 2010 to
2014, indicating that Procter & Gamble consistently pays out its free cash flows to its
investors. The financial accounting ratios show that Procter & Gamble is making good
investment decisions with its cash holdings, while making consistent dividend payments
and stock repurchases. The estimated excess returns that the firm and its shareholders are
making are also good indicators that the firm is investing in profitable projects. In the
following years to come the firm should, maintain its cash returned ratio close to one by
maintaining its dividend payout and adjusting stock repurchases in relation to earnings
and available cash. The firm should also continue to invest its excess free cash flows in
acquisitions or projects that maximize shareholder wealth.

Bankruptcy Analysis
The Altman z-score model is a statistical analysis model that in corporate finance can be
used to estimate the financial health of a firm. The formula to estimate the Z-score is
similar to a weighted average formula it uses five variables each with a unique
coefficient. The following five ratios are the variables, with corresponding coefficients,
used in the z-score model: net working capital over total assets with coefficient 1.2,
retained earnings over total assets with coefficient 1.4, earnings before interest and taxes
over total assets with coefficient 3.3, market value of equity over book value of total
liabilities with coefficient 0.6, and sales over total assets with coefficient 1. Information
used for this estimation of the Z-score was downloaded from Mergent Online. The EBIT
and sales were taken from Procter & Gamble's 2014 income statement. The retained
earnings, total liabilities, total assets, current assets, and current liabilities were taken
from Procter & Gamble's 2014 balance sheet. The market value of equity, previously
estimated in this analysis, is the product of the price per share of common stock and total
number of shares outstanding. The Z-score is the sum of the products of each variable
and its coefficient. The estimated Z-score is interpreted using three interval ranges: less
than 1.81, greater than 1.81 and less than 2.675, and greater than 2.675. It can be

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predicted that a firm with a Z-score that is less than 1.81 will suffer from bankruptcy
within one year. An estimated Z-score between 1.81 and 2.675 indicates a firm that is
under financial distress and the possibility that bankruptcy could occur within the next
year. A Z-score that exceeds 2.675 indicates a firm that is not under financial distress.
The estimated Z-score for Procter & Gamble, 3.41, this indicates that the firm is not
financially distressed. Theoretically, the higher the estimated Z-score, the less a firm is at
risk of bankruptcy. The estimated Z-score for Procter & Gamble is about 28% higher
than the financial distress threshold and about 89% higher than the bankruptcy threshold,
indicating it is very financial stable and has low risk of bankruptcy in the near future. The
biggest impact on Procter & Gamble's Z-score is the fourth variable, the market value of
equity over total liabilities. Procter & Gamble's capital structure, specifically its estimated
use of almost 76% equity, supports it from being less exposed to bankruptcy risk.

Corporate Governance
Introduction
Corporate governance can be described as the umbrella of standards, controls, and
processes of a firm that allow its operation. The board of directors of a firm consists of
the stakeholders that create controls, and monitor the managers. The structure of the
board of directors and their control over the managers prescribes the strength of corporate
governance that a firm has. To determine the strength of corporate governance of Procter
& Gamble five criteria were created. The criteria include the firm’s compliance with
standards and regulations regarding its audit and compensation committee, number of
senior executives on the board of directors, chief executive officer’s position with the
board of directors, a third party corporate governance score, and classes of voting stock.
Morningstar was used to study Procter & Gamble’s corporate governance.
Governance Criteria
Procter & Gamble’s board of directors consists of twelve directors, separated into four
committees: audit committee, compensation and leadership development committee,
governance and public responsibility committee, and innovation and technology
committee. The board of directors consists of a lead independent director and nine other
independent directors. The chairman of the board, Alan Lafley, is the former president

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and chief executive officer of Procter & Gamble. The current president and CEO, David
Taylor, is the only senior executive that sits as a director. The presence of a lead
independent director, and proportionately more independent directors, strengthens the
firm’s corporate governance. The CEO being on the board of directors does not weaken
the firm’s corporate governance. David Taylor is not the chairman of the board, which
strengthens the firm’s governance more. The former CEO sits as the chairman of the
board, but a conflict of interest is not created because he does not sit on any of the
committees and a lead independent director is present. The structure and hierarchy of
Procter & Gamble’s board of directors provide strong corporate governance for the firm.

Regulations on corporate governance were created with the Sarbanes-Oxley Act, one that
requires a board of director’s audit committee to be independent of management and to
have at least one financial expert. Procter & Gamble’s audit committee consists only of
independent directors. The chairman of the audit committee, Patricia Woertz, began her
career working as a CPA for Ernst & Young. The New York Stock Exchange also
requires the compensation committee of a firm to consist only of independent directors,
NASDAQ requires only two independent directors. Procter & Gamble is listed on the
NYSE and meets its requirement. The firm’s compensation and leadership development
committee consists of the lead independent director and two other independent directors.
The firm’s corporate governance is only proven to be stronger with its compliance with
these regulations.

Referring to Procter & Gamble’s articles of incorporation provides information about the
classes of equity stock available to the market. Preferred stock, Class A and Class B are
explained in detail in the articles, about 6% and 2% of total equity shares, respectively.
Class A preferred shares are entitled to one vote per share at shareholder meetings and
Class B preferred shares are entitled to no vote at shareholder meetings. Further reading
provides information regarding the firm’s common stock, ten billion shares and roughly
92% of total equity shares. Common stock shareholders are entitled to one vote per share
at shareholder meetings. Dr. Damodaran states in his text, Applied Corporate Finance,
that corporate governance is likely to be strongest in companies that have only one class

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of shares without different voting rights. The largest majority of equity shares, 98%, have
voting rights, thus Procter & Gamble’s corporate governance can be considered strong by
this criteria. Another indicator of the firm’s strong governance is the lack of control
shares, where a single share from one stock class has more voting power over a single
share from a different stock class. This takes power away from the executive
management unlike other companies with control shares. For instance the CEO of Zynga
Inc., Mark Pincus, has the power of 70 votes per one share of common stock, which
substantially weakens its governance.

A firm’s corporate governance score, provided by a third party rating agency, adds
insight to the strength or weakness of its corporate governance. On Procter & Gamble’s
profile, provided by Yahoo Finance, it shows an ISS Governance QuickScore score of 2.
The Institutional Shareholders Services Governance QuickScore ranges from 1 to 10, low
governance risk to high governance risk, respectively. Procter & Gamble’s score of 2
indicates that there is a low level of concern of its governance risk. The ISS Governance
QuickScore on Yahoo Finance also provided pillar scores, governance scores separated
into four factors, board structure, compensation, shareholders rights, and audit &
oversight. On the same 1-10 scale, Procter & Gamble scored 1, 2, 3, and 4, for audit,
board structure, shareholders rights, and compensation, respectively. These scores are
relatively lowed when compared to a high governance risk firm, like Zynga that scored 2,
4, 6, and 10, respectively, with an overall score of 9.
Conclusion
Corporate governance can be described as the control that a firm’s board of directors
holds in relation to executive management. A firm’s board of directors creates the
governance standards and ensures that management adheres to them. The five criteria
created to assess Procter & Gamble’s corporate governance provide simplistic metrics for
governance. The structure of the firm’s board of directors and number of independent
directors indicates strong corporate governance. Compliance with the SOX Act and
NYSE committee regulations shows that the firm has strong governance within its board
of directors. The firm’s policy on shareholder voting rights and lack of control shares
adds consistency to the strong governance findings. The ISS Governance QuickScore

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indicated low corporate governance risk validating the aforementioned criteria. Procter &
Gamble’s corporate governance analysis showcases its strong corporate governance.

Conclusion
Procter & Gamble is the largest company in its industry and provides countless products
across the world. This analysis has covered Procter & Gamble’s financial statement
analysis, cost of capital, optimal capital structure, dividend policy, bankruptcy analysis,
and corporate governance. Initially the firm’s financial ratios indicated that it could
utilize more debt financing but the financial health of the firm was above average. The
base case weighted average cost of capital was estimated to 6.4%, using the base case
cost of equity and synthetic rating method. Using the firm’s tax rate from its 10k and cost
of debt intervals of one percent resulted with an optimal capital structure of 76% equity
to 24%, matching the current estimated market values of debt and equity. Researching the
firm’s dividend policy showed that the firm is in its mature growth stage and is making
consistent large dividend payouts to its shareholders. The estimated excess returns are
good indicators that the firm is investing in profitable projects. Calculating the firm’s Z-
score for the bankruptcy analysis showed that the firm is not in financial distress and that
the firm is not at risk of bankruptcy within the next year. The firm’s corporate
governance is strong in relation to the set criteria and the third party governance score. It
can be concluded that Procter & Gamble is financially healthy and it should maintain its
current operational and financial structure through out its mature growth stage of its
lifecycle.

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Works Cited:

http://247wallst.com/investing/2012/06/04/companies-where-shareholders-have-no-
power-at-all/

http://pages.stern.nyu.edu/~adamodar/

Damodaran, Aswath (2014-10-16). Applied Corporate Finance, 4th Edition (Page 228).
Wiley. Kindle Edition.

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