Brambles Cost of Capital and Optimal Capital Structure

Introduction

Brambles Limited (BXB) is an ASX-listed supply-chain logistics company operating in more than sixty countries, primarily through the CHEP brand. Brambles helps move more goods to more people, in more places, than any other organisation on earth. Its pallets, crates and containers form the backbone of the global supply chain, and many brands across the world trust Brambles to help transport their goods efficiently, sustainably and safely. Brambles serves the fast-moving consumer goods, fresh produce, beverage, retail and general manufacturing industries.

Pallets: This business, operating under the name CHEP, focusses on outsourced management of returnable pallets, which are issued, collected and reissued through a network of service centres in multiple countries. Manufacturers, producers, distributors and retailers use the pallets and containers to transport their products safely and efficiently through the supply chain. In addition, Pallets provides supply chain optimisation and transport management services. In the USA, Pallets provides a national network of pallet management services, to sort, repair and reissue pallets.

Reusable Plastic Crates: This business operates under the name CHEP in Australia, New Zealand and South Africa, and focuses on outsourced management of reusable plastic containers that are used primarily to transport fresh produce from producers to grocery retailers.

Containers: This business provides intermediate bulk, automotive and chemical and catalyst containers to its customers. It also operates an airline container pooling and repair business, and a non-flight critical aviation equipment maintenance and repair business called CHEP Aerospace.

In this assignment, you will estimate the weighted average cost of capital (WACC) for Brambles, before assessing the optimality of its capital structure.

QUESTION 1

The first step in determining BXBs WACC is to estimate its cost of debt. The cost of debt for a company is usually expressed as the risk-free interest rate plus a credit spread, with the latter accounting for the companys default risk. Credit spreads are typically a function of a companys credit rating, which is determined by a credit rating agency, such as S&P Global, Moodys Ratings, or Fitch Ratings. Debt issued by safer, more secure companies enjoys better credit ratings and lower credit spreads, which translates into a lower cost of debt.

BXB has short-term debt (in the form of unsecured bank loans, bank overdraft facilities, unsecured bills, notes, bonds and commercial paper, and short-term lease liabilities), as well as long-term debt (in the form of unsecured bank loans, unsecured notes, bonds and commercial paper, and long-term lease liabilities). To estimate BXBs credit spread, we shall follow Aswath Damodarans approach, which uses a firms interest coverage ratio (the ratio of its EBIT to its interest expense) to estimate a synthetic credit spread for the firm. This allows us to estimate a firms cost of debt, without any information about its credit rating from a credit rating agency. Firms with large interest coverage ratios are less credit risky, since they can comfortably fund their interest expenses from EBIT. Consequently, such firms enjoy lower credit spreads and a lower cost of debt.

The worksheet Question 1 provides a space for you to estimate BXBs cost of debt over the period 20152024, by entering formulas and/or values in the green cells. To begin with, use the year-end (31 December in 20152023 and 31 August in 2024) 10-year government bond yields as proxies for the risk-free interest rate at the end of each year. Then you should calculate BXBs interest coverage ratio for each year and use the value to determine BXBs synthetic credit rating and synthetic credit spread for the year. To do so, you should apply Excels VLOOKUP function to the table in the Synthetic Credit Ratings worksheet. Adding the risk-free interest rate for each year to the corresponding synthetic credit spread provides an estimate for BXBs cost of debt in that year.

Present the above results in a table in your report and comment on them. Do you think your estimate for BXBs cost of debt is too high or too low? Does BXBs cost of debt appear to be stable over the 20152024 period? Be sure to explain the economic logic behind Damodarans approach and describe the calculations you performed. For comparison, look for information on BXBs agency credit ratings in the companys financial reports, and compare those credit ratings with the synthetic credit ratings you obtained. What are the credit spreads corresponding to BXBs agency credit ratings, and how to they compare with the synthetic credit spreads you obtained? (You will have to do a bit of research to answer
that question.)

QUESTION 2

Since a proper estimate of a firms WACC depends on the market value of its debt and the market value of its equity, our next task is to estimate the market value of BXBs debt. Unfortunately, BXBs debt is not publicly traded, so we cannot simply observe its market value. Instead, we shall follow the approach suggested by the Corporate Finance Institute. Under this approach, we lump the book values of the firms short-term and long-term debt together and treat the sum as the principal (face value) of a single bond issue, whose maturity is the weighted average maturity of the firms debt. The firms annual interest expense may then be regarded as the annual coupon payment on the bond, and the firms cost of debt may be interpreted as the yield on the bond. Using those inputs, we use the bond pricing formula to calculate the price of the hypothetical bond, which we interpret as the market value of the firms debt.

The worksheet Question 2 provides a space for you to estimate the market value of BXBs debt over the period 20152024, by entering formulas and/or values in the green cells. For simplicity, you should assume that BXBs debt has a weighted average maturity of 5 years. Present your estimates for the market values of BXBs debt in a table in your report and explain how you obtained them. What are the weaknesses of the approach you used? What are the percentage differences between the book values of BXBs debt and the market values you obtained? What is the source of those differences?

QUESTION 3

Next, we use the CAPM to estimate BXBs cost of equity at the end of each year in the 20152024 sample period. Following established convention, we regard 10-year government bond yields as a proxy for the risk-free interest rate, while the S&P/ASX 200 index is used as a proxy for the market portfolio. Monthly historical 10-year government bond yields can be found in the Market Data worksheet, together with monthly (adjusted) values for the S&P/ASX 200 index and monthly (adjusted) share prices for BXB. This data will allow you to estimate BXBs equity beta. By combining the equity beta with the risk-free interest rate and an estimate for the Australian equity risk premium, you will be able to estimate BXBs expected return on equity (i.e. its cost of equity), via the security market line (SML) equation for the CAPM.

The worksheet Question 3 provides a space for you to estimate BXBs cost of equity over the period 20152024, by entering formulas and/or values in the green cells. To begin with, you must estimate BXBs equity beta for each year in the sample. To do so, first enter appropriate formulas in the green cells in the Market Data worksheet to calculate the monthly risk-free interest rate, as well as monthly returns on the S&P/ASX 200 index and BXB shares, and monthly excess returns the S&P/ASX 200 index and BXB shares. Use OLS regressions and the previous two years of excess returns to estimate BXBs equity beta at the end of each year in the sample period.2 (You should create new worksheets for the outputs of these regressions.) Based on your interpretation of the regression outputs, enter the equity beta estimates for each year in the sample period, together with the upper and lower bounds for the 95% confidence intervals for the estimated betas, in the appropriate cells in the Question 3 worksheet.

Next, use Excels VLOOKUP function to enter the year-end (31 December in 20152023 and 31 August in 2024) 10-year government bond yields in the cells for the risk-free return in each year. Finally, enter the estimates for the Australian equity risk premium provided by GuruFocus in the cells for the equity risk premium.3 By combining the previous data with the SML equation, you will obtain your estimate for BXBs cost of equity at the end of each year.

Present your estimates for BXBs equity betas over the period 20152024 in a table in your report, together with the 95% confidence intervals for your beta estimates, and explain how you obtained them. Comment on the stability of your estimates for BXBs equity beta over the period. Are you confident in the accuracy of your estimates? What could you do to improve them? Does the value of BXBs equity beta surprise you, given the nature of the companys business?

Present your estimates for BXBs cost of equity in the same table as above and explain how you calculated them. Do you think BXBs cost of equity is high or low, compared with the cost of equity for other Australian companies? Justify your answer by referring to BXBs equity beta.

QUESTION 4

The final ingredient for estimating BXBs WACC is the market value of its equity. The worksheet Question 4 provides a space for you to calculate the market value of BXBs equity over the 20152024 period, by entering formulas and/or values in the green cells. You should estimate the year-end market value of equity for BXB, for each year in the period, by multiplying the end-of-period number of shares outstanding (disclosed in the profit and loss statement) by the companys end-of-year share price (which you should obtain by applying Excels VLOOKUP function to the table in the Market Data worksheet). For 2015 to 2023, you should use the share price on 31 December, but for 2024, you should
use the share price on 31 August.

Include a table in your report containing the number of BXB shares outstanding at the end of each year, together with BXBs share price and the market value of its equity at the end of the year. Add two more rows to the table, containing the book value of BXBs equity and the companys market-to-book ratio, for each year in the period. Explain what BXBs market-to-book ratio measures and interpret the trend in the ratio.

QUESTION 5

Now you need to put everything together, by calculating BXBs WACC for each year in the 20152024 period. The worksheet Question 5 provides a space for you to do this, by entering formulas and/or values in the green cells. Present your results as a table in your report and explain how you estimated BXBs WACC. Pay special attention to how you estimated the companys tax rate.

Prepare a graph illustrating BXBs WACC over the 20152024 period, together with the evolution of its costs of debt and equity over the period. What can you say about the time-series behaviour of BXBs costs of capital? Do you think your estimates for BXBs WACC are likely to be too high or too low? Which assumptions and/or values in the WACC calculations are you most uncertain about?

Compare your 2024 estimate for BXBs WACC with the most recent estimate published by GuruFocus. What are the main drivers of the difference between their estimate and yours? Briefly explain how GuruFocuss WACC estimation methodology differs from the approach you have taken? What is the risk for BXB, if its managers use your WACC estimate for capital budgeting decisions, but the GuruFocus estimate is more accurate?

QUESTION 6

To conclude the assignment, you are going to analyse the optimality of BXBs capital structure. Recall that higher levels of debt affect the value of firm in two countervailing ways:

More debt increases the debt tax shield, which increases the value of the firm

More debt also increases financial distress costs, which decreases the value of the firm

The optimal capital structure is the mixture of debt and equity that achieves the best tradeoff between these two opposing forces, thereby maximising the value of the firm. The worksheet Question 6 provides a space for you to analyse BXBs capital structure, based on its 2024 financial results. As before, you will be required to enter formulas and/or values in the green cells in the worksheet. Note that this worksheet contains circular references, which Excel can resolve through iterative calculations. For this to work, you must set Excel up to allow circular references.

The table Financial Data on 31 August 2024 summarises the current financial state of BXB. The first thing you should do is enter a formula in cell B9 in this table that expresses BXBs unlevered cost of capital as a function of its current costs of debt and equity and its current debt-to-equity ratio.4 (You can derive the formula by inverting the formula in the slides for Module 4 that relates a firms cost of equity to its unlevered cost of capital, its debt-to-equity ratio, and its cost of debt.)

The next step is to complete the green cells in the Capital Structure Scenarios table. (This is the table that contains the circular references.) The table presents several capital structure scenarios, in the form of debt-to-equity ratios ranging between 0% and 100%. The objective is to estimate BXBs WACC (in row 24) for each scenario. Begin by entering formulas in the cells in row 17, which should calculate the market value of BXBs equity under each capital structure scenario. To derive the appropriate formula, we need to make the following assumption: The sum of the market values of BXBs debt and equity remains constant under each scenario. (In other words, we are assuming that BXBs capital structure does not affect the total market value of all its securities.) With that assumption in place, we can express the market value of BXBs equity as a function of the sum of the market values of its debt and equity and its debt-to-equity ratio. Having entered the formulas in row 17 for the market value of BXBs equity under each capital structure scenario, it is easy to derive the correct formulas for the market values of its debt in row 18.

Next, you should enter formulas for BXBs cost of equity in row 23. A firms cost of equity should increase as its debt-to-equity ratio increases, since leverage increases equity risk (remember that equity represents a residual claim on a firms assets). Here we shall make the nave assumption that BXBs cost of equity increases linearly as a function of its debt-to-equity ratio. To determine a straight line (i.e., a linear function), we only need to know two points on the line. That is to say, we only need to know BXBs cost of equity for two different debt-to-equity ratios. Fortunately, we have that information:

When BXBs debt-to-equity ratio is zero, its cost of equity is its unlevered cost of capital in cell B9

When BXBs debt-to-equity ratio is given by cell B8 its cost of equity is given by cell B5

Use Excels FORECAST.LINEAR function to estimate a linear dependence between BXBs cost of equity and its debt-to-equity ratio, by fitting a straight line through the two points above. This will allow you to complete row 23.

Now for the circular references. Enter formulas in rows 16 and 19 that use VLOOKUP to select BXBs credit rating and credit spread from the table in Synthetic Credit Ratings worksheet, for each debt-to-equity ratio scenario, based on the interest coverage ratios in row 22. (Note that the cells in row 22 are still emptyyou will fill them shortly.) Enter formulas for BXBs cost of debt for each capital structure scenario in row 20, by adding the corresponding credit spread in row 19 to the risk-free return in cell B10. Enter formulas in row 21 for BXBs interest expense under each capital structure scenario, by multiplying the cost of debt in row 20 by the market value of debt in row 18. Enter formulas in row 22
for BXBs interest coverage ratio under each capital structure scenario, by dividing the firms EBIT in cell B12 by the interest expense in row 21.5 Finally, enter formulas for BXBs WACC under each capital structure scenario in row 24. Since BXBs cost of equity increases linearly as its debt-to-equity ratio increases, while its cost of debt increases sporadically due to the larger credit spreads associated with more leverage, you should observe that its WACC is an increasing function of its debt-to-equity ratio as well.

The Profit and Loss Statement Scenarios table presents BXBs 2024 profit and loss statement under each of the capital structure scenarios. All you have to do is enter straightforward formulas in rows 3741 and row 45. We shall interpret the reported NPAT after abnormals in row 45 as BXBs FCFF for the next year. Using the FCFF and WACC for each debt-to-equity ratio scenario, together with the assumed long- term annual growth rate of 3.5% in cell B11, we can estimate BXBs firm value under each scenario, with the help of the constant-growth perpetuity formula. The formulas for doing this should be entered in row 48. But we need to adjust them to account for financial distress costs. Here we shall follow the approach of (Almeida & Philippon, 2008), who estimate financial distress costs expressed as penalties on firm value. The fifth column in the table in the Synthetic Credit Ratings worksheet incorporates the financial distress costs from Table 1 in that article. Use Excels VLOOKUP function to select the appropriate financial distress cost for each capital structure scenario and use it to adjust the corresponding firm value in row 48.

If you have done everything correctly, the pre-entered formulas in row 49 should indicate which debt-to-equity ratio maximises BXBs firm value. Based on the values in that row, which debt-to-equity ratio is optimal for BXB? What should the company do, in order to improve its capital structure? Plot a graph of BXBs WACC as a function of its debt-to-equity ratio in your report and plot a similar graph of the companys firm value as a function of its debt-to-equity ratio. Comment on the graphs. In the analysis above, we made several simplifying assumptions. What are the most unrealistic assumptions, in your opinion, and how do you think they affected the analysis?

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