Question

You have recently been hired by Bio Lux Company, in its relatively new treasury management department. Bio Lux was founded five years ago by Jessica Parker. Jessica found a method to produce high quality shampoo using natural ingredients. The shampoo produced by Bio Lux is in a good position to compete with other more established shampoo producers. The company is privately owned by Jessica Parker and her family, and it had sales of $12 million last year.

Bio Lux primarily sells its products through a wholesaler who distributes the products through its network of retailers throughout the country. Bio Lux’s growth to date has come from its innovation, quality, and low costs. When the company had sufficient capital, it would expand production. Relatively little formal analysis has been used in its capital budgeting process. Jessica has just read about capital budgeting techniques and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Jessica would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. Jessica wants you to use a similar company to estimate the cost of capital (WACC) for Bio Lux, and she has chosen Procter & Gamble as a representative company. The following questions will lead you through the steps to calculate this estimate.

Go to Nasdaq.com and find the list of competitors in the industry. You can do this by clicking on the search window, then enter PG (which is the ticker of Procter & Gamble). The list of competitors of the company will be available when you click on “Competitors” in the left vertical menu. Use U.S.-based competing companies for this task.

1. a) Find the beta for each of these competitors, and then calculate the industry average beta.
2. b) Using the industry average beta, what is the cost of equity?
3. c) Does it matter if you use the beta for Procter & Gamble or the beta for the industry in this case?

Answer 1

Company	beta
Procter & Gamble	0.22
Revlon	0.34
Unilever PLC	0.53
e.l.f. Beauty	1.65
Market average	0.685

The industry average beta for Household & Personal Products industry as calculated from average of the above competitors is 0.685. Note that beta has been captured from Yahoo Finance.

Cost of equity can be calculated by CAPM formula as below-
Expected return (cost of equity) = risk free rate + beta*(Market return- risk free rate)

risk free rate (3 months treasury rate)=	2.46%
beta=	0.685
market return (avg 10 years)=	7.12%
Expected return (cost of equity) = risk free rate + beta*(Market return- risk free rate)	5.65%
	=2.46%+0.685*(7.12%-2.46%)

The market average beta and beta for P&G are very different. If we use the P&G beta of 0.22, then the cost of equity comes out to 3.5% which is very low as compared to that calculated previously using market beta. If we have to chose 1 between market beta and P&G beta, we should use market beta. It should be noted that P&G and Bio Lux are very different in many ways. P&G is a well diversified and very old company with market leadership under many brands. On the other hand, Bio Lux is relatively new company with only 5 years of experience, has only selective or niche product range and does not appear to have market leadership in its segment. Additionally, it is a very small company which is not listed on the stock exchanges. Hence, the risk systemic risk and beta for Bio Lux is expected to be much higher than P&G or even other established companies in the market.