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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

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.

1

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.

2

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

3

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

4

that as Procter & Gamble increases their assets, effectively increasing liquidity, their

asset turnover decreases.

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

5

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

6

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.

7

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

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.

8

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

9

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

10

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.

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

11

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 &

12

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

13

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:

14

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.

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.

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%.

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 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

20

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

21

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%

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

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

28

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

29

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

30

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

31

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

32

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.

33

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.

34

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