Consistency in Chocolate. A Fresh Look at Copeland's Hershey Foods & Co Case

In cash flow valuation, on grounds of simplicity, it is common to assume that the leverage is constant over time. With constant leverage, the return to levered equity is constant and consequently, the Weighted Average Cost of Capital (WACC) applied to the Free Cash Flow is constant. However, typically the constant leverage is not reflected in the financial statements. Specifically, the values of the annual debt (as listed in the balance sheet) as percentages of the annual levered values are not constant. The Hershey case study in the popular book on valuation by Copeland et al. (2nd edition, 1995) is a good illustration of this common and widespread inconsistency. Distressingly, readers may not realize or recognize the inconsistency between the cost of capital and the financial statements and authors of textbooks make no attempt to mention it. The consistency between the leverage assumption in the WACC applied to the FCF and the values for the debt in the balance sheet can be resolved if the debt is rebalanced each year to maintain the constant leverage. In this paper, we demonstrate the inconsistency. First, we calculate the annual leverage and show that it is not constant. Second, we calculate the annual equity by subtracting the annual debt values from the annual levered values and demonstrate the discrepancies with the present value of the CFE. This paper is aimed to those who have learnt valuation with that edition (1995)