Amgen Case Weighted Average Cost of Capital

MBAC 6060 – Spring 2011 David M. Gross, Ph.D.

Amgen Case – Weighted Average Cost of Capital

This assignment is due at the beginning of class on Tuesday April 12.

It is April 4, 2011 and you need to estimate the Weighted Average Cost of Capital for Amgen. The goal of the case is to use market data on the common stock and bonds issued by Amgen as well as general market data to calculate Amgen’s Weighted Average Cost of Capital.

When finished, please rename your spreadsheet using the group-member’s name that is first alphabetically email the spreadsheet to me at [email protected].

Company background (from Google Finance): Amgen Inc. is an independent biotechnology medicines company. Amgen discovers, develops, manufactures and markets medicines for grievous illnesses. It focuses on human therapeutics and concentrates on medicines based on advances in cellular and molecular biology.

The formula we will use for the Weighted Average Cost of Capital is: WACC = WERE + WDRD(1 – TC)

Note that Amgen does have some convertible bonds outstanding, but we will ignore these under the assumption that Amgen would finance new operations using only “straight debt” and equity.

Cost of Equity

We will use the CAPM to calculate the cost of equity for AMGN: RE = Rf + β[E(RM) - Rf]. To do this, we need the risk-free rate, the company’s equity beta, and the expected return on the market.

 The Treasury Direct website shows the one-year Treasury rate for April 4, 2011 is 0.24%. Please use this as the risk-free rate.

 The “Beta Data” tab in the spreadsheet contains monthly prices for AMGN stock and the S&P500 for the last 61 months from the Yahoo Finance site. Please use this data to calculate 60 months of returns for AMGN and the S&P500.

Next calculate the AMGN’s equity beta by calculating the slope of the regression line for return on AMGN regressed on the return of the S&P500. Use either the “Regression” tool in the “Data Analysis” pop-up box, the “LINEST()” function, the ratio of the covariance of the returns to the variance of the market return (be sure to use VARP) or any other method in Excel. See the “AAPL Beta” spreadsheet on the course website for examples. Please report the beta to four decimal places.

 The “Annual S&P500” tab on the spreadsheet shows the December S&P500 close for the past 61 years (from 1950, the start year for Yahoo Finance data). Use these prices to calculate 60 annual returns for the S&P500. Next calculate the average annual return over the last 60 years for the S&P500. Please use this as the expected return of the market. (Note that 61 years and 61 months of data are coincidental. Sixty months of returns is standard for beta calculations. Sixty-one years is length of the Yahoo Finance data set.)

 Please apply the CAPM to calculate the cost of equity (RE) for AMGN.

1 Cost of Debt

The “Debt Data” tab contains information on thirteen outstanding bonds issued by Amgen. The data was collected on April 4, 2011 from the FINRA bond price site. Use this information to calculate Amgen’s costs of debt.

 Since we are looking at actual bonds, please use the “YIELD()” function in Excel to calculate the yield to maturity (YTM) for each of the 13 outstanding issues.

Recall that the YTM calculation includes the current price of the bond and therefore accounts for the capital gain or loss incurred by the bond holder as a function of the market price. Therefore the YTM is a better indication (compared to the coupon rate) of what AMGN would need to pay if it were to issue new bonds.

The YIELD() function works differently from the RATE() function. To use the YIELD() function you need: YIELD(settlement, maturity, rate, pr, redemption, frequency, [basis])

(a) settlement: The date on which the bond is to be analyzed (April 4, 2011) (b) maturity: The date on which the bond matures (given in the data table) (c) rate: The coupon rate in annual (APR) terms (given in the table) (d) pr: The price per $100 of face value (not % of par) (e) redemption: The redemption value per $100 of face value. Please use $100. (See the note on redemption value below.) (f) frequency: The number of coupon payments per year. (These are all semi-annual bonds.) (g) basis: The “basis” is the day-count convention. For corporate bonds use “30/360.” This is the default method of calculation if this input is left blank.

For example, the YTM for the 0.38% coupon bond maturing on Feb 1, 2013 is: YIELD(settlement, maturity, rate, pr, redemption, frequency, [basis]) YIELD(settlement,maturity,0.0038,99,100,2) = 0.00934 = 0.934%

Note that you cannot type the settlement date of 4/4/2011 or maturity date of 2/1/2013 into the formula. You must enter the values (as dates) in two different cells and reference the cells in the formula.

Repeat this procedure to calculate the YTM for each of the 13 outstanding bond issues.

Note on redemption value: The Excel YIELD() function can also be used to calculate “yield-to-call” for a bond. Callable bonds often have redemption values that exceed par value in order to compensate the holder for the early call. The “redemption” input variable allows you to enter a value different from the face value to account for this possibility.

 Calculate the total market value of each issue by multiplying the price as a percentage of par by the Outstanding Face Value. Sum these values to get the total market value of debt for AMGN.

 Next calculate the market weight of each issue. Next multiply the market weight by the YTM for each issue. Sum these values to get the market weighted YTM for AMGN’s debt. Please use this as

AMGN’s cost of debt (RD)

2 Note that by using only the public bonds, we ignore the interest rate AMGN is paying on its private debt. Private debt includes money borrowed from banks or borrowed from large managed pools of money such as insurance companies and pension funds through the use of private-placement bonds. For AMGN, this does not seem like a big problem since its balance sheet shows a total debt amount near the market value of debt calculated above.

The Corporate Tax Rate

 Use the data on the “Tax Data” tab to calculate the effective tax rate for AMGN over the last three years. The effective tax rate is the Tax Expense divided by the Income Before Taxes. Please use the

average three-year effective corporate tax rate for AMGN as the tax rate (TC) in the WACC equation.

Market Value Weights

 Please use the total market value of debt calculated above.

 The market price of AMGN on April 4, 2011 was $54.03. The number of shares outstanding at the time of most-recent filing was 932,452,902. Use these values to calculate AMGN’s market value of equity.

 Use these values to calculate AMGN’s weight of equity (WE) and weight of debt (WD)

Weighted Average Cost of Capital

Use the values calculated above to compute AMGN’s WACC.

Questions:

1. Please produce tables showing your interim values and results. Please be sure to show the following

values: Equity beta, Rf, E(RM), RE, RD, Stock Price, # of Shares, E, D, V, WE, WD, TC, and WACC

2. Briefly interpret AMGN’s WACC. How does the WACC relate to a project’s Internal Rate of Return?

3. A colleague has examined the historic annual returns for AMGN between 1984 and 2010 and shows you the average annual return for AMGN has been 40.97% over that period. Why, asks your colleague, should you not use 40.97% as the required return on equity for AMGN’s stockholders in calculating the company’s cost of equity capital? Please write a short explanation of why the CAPM

RE of 4.0038% is a better value to use than 40.97%. What assumptions are we making by using the CAPM cost of equity?

4. We used the weighted average YTM of AMGN’s public debt to calculate its cost of debt. Apart from ignoring the private debt, what assumption are we making using this value in AMGN’s WACC calculation?