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UVA-F-0982Mead Corporation: Cost Of Capital

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UVA-F-0982

This case was prepared by Kenneth Eades for the purposes of classroom discussion. Some figures have been changed at

the request of the company. Copyright1991 by the University of Virginia Darden School Foundation, Charlottesville,VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publicationmay be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means

electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School

Foundation. Rev. 5/95.

MEAD CORPORATION: COST OF CAPITAL

On February 14, 1991, Cheryl Harris, business analyst at Mead Corporation, had just begunthe process of estimating Meads cost of capital for the fourth quarter of 1990. Like most othermajor corporations, Mead used its weighted-average cost of capital (WACC) to evaluate newinvestment proposals as well as to measure corporate and divisional performance. Mead wasunique, however, in its practice of updating the hurdle rate every quarter and analyzing the factorsresponsible for its change. Looking back at the companys history of WACC estimates, Ms. Harrisobserved that Meads cost of equity had been increasing relative to its cost of debt over the past few

years. Hence, as part of her analysis, she hoped to explain why the cost of equity had increased and

recommend whether the company should consider the increase a problem. Her more immediateconcern, however, was the presentation she was to give the next morning to William Enouen,Meads chief financial officer, who had asked to see Ms. Harriss WACC estimate.

Mead Corporation

Mead Corporation was founded in 1846 by Daniel E. Mead and incorporated in 1930. In theensuing years, Mead, Inc., grew to become a leading producer of paper and forest products.Included in the companys product line of forest derivatives were printing paper, writing paper,specialty paper, lumber, wood pulp, corrugated containers, and packaging products. The company

also owned and operated a national distribution network for paper packaging and supplies. Forbeverage packages and packaging systems as well as for paper-based school and office supplies,Mead was the leading manufacturer in the United States.

In addition to its forest and paper-based products, Mead had been involved in electronicpublishing and the development of color imaging. Mead Data Central (MDC), a wholly ownedsubsidiary of Mead, Inc., owned several publishing companies--for example, The Michie Companyin Charlottesville, Virginia, which published and distributed the legal statutes of 23 states. MDCalso marketed the LEXIS and NEXIS information services. LEXIS was a computer-based data-retrieval system designed for legal research that had been expanded to include financial informationfrom leading investment banks, brokerage firms, and research companies. NEXIS was an on-line

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UVA-F-0982-2-general-information-retrieval service frequently available in libraries and news departments of theprint and broadcast media.

After having invested approximately $200 million over five years in the development of itscolor-imaging process called Cycolor, Mead had announced in December 1990 that the demandfor color copying was growing too slowly to justify remaining in the business. The writeoffsassociated with the discontinuance had resulted in Meads fourth-quarter earnings per share fallingfrom the third-quarter figure of $0.63 to $0.17. The company projected that the writeoffs would becompleted before the second quarter of 1991, at which time profits were expected to return tonormal. The announcement regarding discontinuation of its color-imaging business did not appearto have adversely affected Meads common stock price, which had risen to $25.75 on December 31,1990, from $24.25 on October 1, 1990.

Meads Cost of Capital

Mead had conducted an internal study in 1984 of the companys cost-of-capital calculationmethod. Subsequently, top management implemented a strategy to estimate the cost of capital eachquarter and decompose it into its components for comparison with historical estimates. The cost ofcapital had become an important benchmark for measuring both corporate and divisionalperformance. Although several other factors were used in the evaluation of Meads divisions,earning a return on investment greater than the cost of capital was considered the single mostimportant performance measure. One of the recommendations of the study was that the MDCdivision, because of its higher risk, should be held to a higher required rate of return standard thanthe rest of the companys divisions. Thus, while the other divisions were evaluated against the

companys WACC, MDCs performance was compared with Meads WACC plus an additional 4percent.1 The same 4 percent risk premium had been used for MDCs cost of capital since 1984.

In addition to measuring internal performance, the cost of capital also served as a barometerof the external markets perception of the company. For example, the cost of equity reflected themarkets assessment of the companys risk. If senior managements assessment of Meads risk wassubstantially less than the markets, the company could take advantage of the markets pricing byexecuting a share-repurchase program. Following the stock market crash in 1987, Mead repurchasedapproximately 282,000 shares on the open market. In 1990, the company repurchased 5.0 millionshares at an average price of $26.69, which approximated the companys 1990 book value of $26.28per share.

Studying the components of the WACC allowed management to discriminate betweenchanges in capital costs caused by macroeconomic variables such as interest rates and changes

caused by firm-specific variables such as the companys beta or its capital structure. Changes infirm-specific variables were considered to be somewhat under managements control, whereas a

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