Grand Metropolitan Plc

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The issue:
Grand Metropolitan PLC is the world’s largest wine and spirits seller. It mainly operated in London, USA. In 1991, it beats market expectation with a 4.8% increase in pretax profits, and the company Chairman stated that company’s goal “to constantly improve on”. Despite the great performance in the world recession in 1991, the price of GrandMet shares was 10% below the average price/earnings ratio of the companies in the Standard & Poor’s 500 index. And more important, rumors had that GrandMet, valued at more than $14 billion in the stock market, maybe a takeover target. The management dilemma is to understand why the company’s stock is traded below of what considered being the right price and whether the company is truly being undervalued by the market or there are consistent issues with negative NPV projects and lines of businesses.

WACC calculation
I.Cost of debt
The purchasing power parity implies the following relationship between the home (GB £) and local (US $) costs of debt:

Local rd$ = (1 + Home rd£) {(1 + local inflation i$)/(1 + Home inflation i£)} -1 => rd£ = (1 + rd$)*(1 + i£)/(1 + i$) -1 = (1+ rd$)*1.043/1.027 -1(from case Exhibit 9)
= (1+ rd$)*1.015579 - 1

Similarly to convert the small amount of debt issued in Germany, we use the relative inflation rates of the two countries to get:

rd£ = (1+ rdDM)*1.043/1.04 = (1+ rdDM)*1.00288 - 1

Total debt outstanding by country are given in Exhibit 6 of the case, we use the market value of the unspecified (long term) debt in our WACC calculations:

US outstandings: Vd$ = 3,137+152+110 (Market values) = $3,399M
Vps$ = 11.0 (Market value of preferred stock outstandings)

British outstandings: Vd£ = 1,794.8+87+63 (Market values) = £1944.8M
Vp£ = 6.3 (Market value of preferred stock outstandings)

Estimated average costs of debt and preferred stock is given in Exhibit 7 of the case:

Weighted average cost of debt (pretax) in Great Britain = rd£ = 8.63% Weighted average cost of preferred stock in Great Britain = rp£ = 10.27%

Similarly for the US operations:

Weighted average cost of debt (pretax) in the US = rd$ = 6.96% Weighted average cost of preferred stock in the US = rp$ = 8.57%

At this point we will ignore the impact of German debt, since the inflation rates are similar in the two countries and also since only 2% of the debt is in German bond issues,

USConvert to costs in home currency (GBP) assuming purchasing power parity Cost of L/T debt6.96%8.626%
Cost of Preferred Stock8.57%10.261%
Market Value of L/T debt: $ 3,399M £1,944.5
Market Value of Preferred Stock: $ 11M £6.3
GB
Cost of L/T debt 8.63%
Cost of Preferred Stock10.27%
Market Value of L/T debt£1,944.8M
Market Value of Preferred Stock: £6.3M
Spot Rate = 1.748 $/GB£
Total L/T debt + Preferred Stock Outstanding:£3901.9M
WAVG Cost of Debt (rd) =8.633%

Thus we can formulate the debt side of the WACC as:
(1-T)*rd*Vd/Total Capital; where rd is the weighted average cost of debt of the US and British L/T debts and preferred stock.

From the above calculations, we find the total L/T debt + Preferred Stock Outstanding (in both US and Britain) = Vd = £5361.10M Thus the WAVG Cost of Debt (including L/T debt and preferred stock) = rd = 8.633%

Using a tax rate of 35%, Vd = £3901.9M, rd = 8.633% and Total Capital of £9187M (all debt and book value of equity from the balance sheet – exhibit 3) we get (1-T)*rd*Vd/Total Capital = 2.4%

II.Cost of equity
To calculate the cost of equity the Grant Metropolitan has to consider several different criteria. According to the footnote 3 on page 2 the Grant Metropolitan actual stock is not traded on New York stock exchange. The NY stock exchange trading is in the form of American Depository Receipts. Using this information we can conclude that Grant Metropolitan stock is listed only in London stock exchange. So if the Grant Metropolitan needed to issue additional...
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