Royal Mail PLC

UV7254
Rev. Apr. 3, 2017
Royal Mail plc: Cost of Capital
As Hillary Hart, senior financial analyst at the British postal service company Royal Mail plc (Royal Mail),
approached company headquarters near Blackfriars Bridge in London, she reflected on the momentous nature
of the seven years she had spent in that building. During that time, the company had faced important changes
in broad demand for letters and parcels, significant restructuring of government regulation, competitive entry
into its long-standing monopoly position, deep workforce cuts, wide-scale labor negotiations and strikes, and,
lastly, the transition from 500 years as a government-owned enterprise to a massive for-profit company traded
on the London Stock Exchange.
Now on July 21, 2015, Hart had an upcoming meeting with several senior managers of the company.
Central to the meeting was an evaluation of the cost of capital for Royal Mail. The cost of capital had become
a point of discussion for two reasons. First, since privatization, Royal Mail was increasingly looking to shed its
government-based decision-making policies of the past for a more market-based orientation. The adoption of
an investor-oriented cost-of-capital benchmark provided an important step in moving forward the governance
of company investment policy. That said, it was by no means easy to shift company objectives toward rewarding
investors and away from a focus on facilitating national employment and communication needs. Second, the
company was under an important review by the British regulatory authority, the Office of Communications
(Ofcom). Deregulation of private postal services was still very much an experiment in Britain. Due to recent
competitive events in the country, Ofcom was reevaluating existing regulatory policies. The cost of capital
provided an appropriate benchmark by which to properly assess the profitability of Royal Mails operations and
the viability of Royal Mails operations under the existing regulatory policies.
Royal Mail plc
Royal Mail originated in 1516 when King Henry VIII established Sir Brian Tuke as Master of the Posts
with the charge to organize a postal service to carry mail between British cities. Throughout its long history,
Royal Mail proved to be the worlds foremost pioneer in postal services. The company introduced many
features that became ubiquitous to postal services worldwide. In 1661, the Royal Mail postmaster introduced
the first postmark with the declaration [in his own spelling], A stamp is invented that is putt upon every letter
shewing the day of the moneth that every letter comes to the office, so that no Letter Carryer may dare detayne
a letter from post to post; which before was usual.1 In the late 1700s, Royal Mail was the first postal service to
operate a fleet of independent mail coaches and outfit postal carriers in uniforms. In 1840, Royal Mail was the
first mail service to offer letter delivery services throughout the entire country for a single rate. To certify
postage prepayment in such a system, Royal Mail invented the postage stamp. The original postage stamp, the
Penny Black, was a one-penny stamp bearing the face of Queen Victoria (see Exhibit 1), and provided prepaid
1 John G. Hendy, The History of the Early Postmarks of the British Isles from Their Introduction Down to 1840, (London: L. Upcott Gill, 1905), 204.
This public-sourced case was prepared Professor Michael J. Schill. Although all data used in the case is based on public sources, some of the characters
and situations in the case are fictitious. Copyright 2017 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights
reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.
This document is authorized for use only in DR. FAIZAH ISMAIL's SEMINAR IN FINANCE_1 course at Universiti Utara Malaysia, from September 2017 to March 2018.
Page 2 UV7254
postage for letters of up to half an ounce to be delivered anywhere in Great Britain and Ireland. In recognition
of Royal Mails role in developing the first postage stamp, British stamps remained throughout the world as the
only postage stamps that did not specify the country of issuance on the stamp. In the mid-19th century, Royal
Mail introduced letter boxes where senders could simply deposit letters to be sent with the affixed paid postage.
Now, due to the dramatic changes in postal services demand at the beginning of the 21st century, it was
once again a time for innovation at Royal Mail. In 2006, the British government had removed Royal Mails
monopoly status, allowing private companies to compete in collecting and sorting mail in the United Kingdom.
With the change, government regulation was reduced, and Royal Mail was freed to set its own postage rates.
Over the next six years, Royal Mail responded by increasing the price of First-Class postage from 32 pence to
60 pence.
In 2011, Parliament passed the important Postal Services Act. In this Act, the Postal Services Commission
was disbanded and the regulatory purview of postal services in the United Kingdom shifted to the Ofcom. The
intent was to dramatically alter the regulation of Royal Mail. Despite the increased liberties, however, the Act
designated that Royal Mail was required to maintain six-days-a-week, one-price-goes-anywhere universal service
for letters regardless of the ownership structure of the company.
A decision to privatize the British mail service followed a government conclusion that Royal Mail was less
efficient and disciplined than many other post offices elsewhere in Europe, and that it urgently needed
commercial confidence, capital, and corporate experience to modernize quickly and effectively.2 This need
followed a sustained worldwide decline in letter volume in the first decade of the twenty-first century as a result
of the substitution of electronic communication. Vince Cable, the UKs Business Secretary, had argued his
position before the House of Commons: The governments decision on the sale is practical, it is logical, it is a
commercial decision designed to put Royal Mails future in a long-term sustainable business.3 Over the years
since deregulation, the financial performance of Royal Mail improved and its operating margin was up fourfold.
Cash flow for the company had grown from negative GBP504 million in fiscal year 2009 to positive
GBP282 million in fiscal year 2013.
The privatization of Royal Mail came in October 2013, when the British government sold 60% of its
1 billion shares of Royal Mail to the public for 330 pence each. The transaction generated proceeds of
GBP2 billion. Of the shares sold, 73% were sold to institutional investors and 23% were sold to 690,000
individual investors.4
On Royal Mails first day of trading on the London Stock Exchange, its share price rose 38% to 455 pence.
Despite high-profile strikes by postal workers who were strongly opposed to the privatization, the share price
for Royal Mail rose in the months following the sale. By January 2014, the share price was trading at over 600
pence, a more than 80% increase over the sale price. Although the share price suffered a substantial price
reversal in mid-2014, over the first six months of 2015 Royal Mail shares had recovered and closed on July 20th
at 511 pence. Exhibit 2 provides a history of returns to Royal Mail equity investors relative to returns in the
broad FTSE 100 Index since October 2013. Despite the strong and growing profits and assets, there was still
substantial uncertainty about the value of the shares.
Two sources of uncertainty were competition and regulation. In April 2012, the Dutch postal service
company TNT had entered the UK door-to-door postal services market with a subsidiary business that would
eventually become known as Whistl. Over the ensuing years, the financial viability of the venture had proved
challenging. Just last month, Whistl management had announced that the company would be suspending its
2 The Privatisation of Royal Mail, National Audit Office, March 27, 2014, 5.
3 Jennifer Rankin, Royal Mail Privatization Will Not Affect Postal Delivery, The Guardian, July 10, 2013.
4 National Audit Office, 43.
Page 3 UV7254
door-to-door business to focus on its bulk mail processing service in Britain. It would rely on Royal Mails
infrastructure for the final mile of delivery service. Two thousand Whistl employees were laid off. The British
government responded by calling into question Ofcoms regulatory policies. In response, Ofcom began a high-
profile review of the postal services market in an effort to stimulate competition. One concern was that Royal
Mail maintained pricing power in the market such that it could engage in anticompetitive pricing. Such
allegations raised the question of what was the appropriate level of profitability for a firm such as Royal Mail.
Moya Greene, CEO of Royal Mail, expressed the companys willingness to fully comply with the review.
She also indicated that Royal Mail was facing difficulties of its own but was determined to continue to get
better. She specifically stated:
This has been a challenging year. Through a continued focus on efficiency and tight cost control, we
have offset the impact of lower than anticipated UK parcel revenue this year, so that operating profit
before transformation costs is in line with our expectations. It has also been a year of innovation, with
a range of new initiatives delivered at pace. We have introduced around 30 new projects, including
services, products and promotions, to improve our customer offering.5
One example was the recent announcement that the company was pursuing an efficiency objective by
purchasing 76,000 hand-held scanner devices from Zebra Technologies. Other initiatives included upstream
investment opportunities such as the acquisition of online shopping platforms such as Mallzee and StoreFeeder.
Just that morning, Greene had issued an update on the company performance for the most recent quarter
and emphasized substantial success and concerns. She reported that strong performance from the parcels
business was offsetting declines in letter delivery revenue, and that the company was committed to investing in
innovation and efficiency.6 She cautioned that the rest of years performance would depend on the critically
important Christmas period. Exhibit 3 shows historical data on Royal Mail unit volume. Exhibits 4 and 5
provide historical financial statements for Royal Mail.
The Cost of Capital
The cost of capital was theoretically defined as the prevailing return that investors could earn on alternative
investments of similar risk. As such, it was inherently a figure determined by market forces rather than by the
company. One attractive feature of the cost of capital was that it provided an opportunity cost benchmark for
evaluating investment returns. Business returns that were expected to exceed the cost of capital were considered
value creating to investors since the expected returns exceeded what investors could generate on their own with
investments of similar risk. Business returns that were expected to be less than the cost of capital were
considered value destroying to investors. Moreover, the cost of capital provided an estimate of the fair return
for investors in competitive businesses. It was expected that businesses in competitive markets would, on
average, earn their cost of capital.
In estimating the cost of capital it was common to consider all capital used in the business. To estimate the
opportunity cost of total business capital, it was common to use a weighted average of the prevailing required
return values for the various types of investors in the business, such as debt holders and equity holders. This
approach was called the weighted average cost of capital (WACC).
5 Royal Mail plc Full Year Results 201415, Royal Mail plc, May 21, 2015.
6 Royal Mail plc press release, July 21, 2015.
Page 4 UV7254
In response to the burgeoning interest in a cost of capital estimate for Royal Mail, Hart had asked a
colleague, Kyle Brooks, to provide an estimate. Given the unique nature of Royal Mails business and its limited
life in public capital markets, Hart recognized that this was not an easy task. Still, Brooks had quickly generated
an estimate of 3.828% and provided a stack of documentation. Exhibit 6 provides his analysis and summary.
Exhibits 7 through 9 provide his supporting documents.
Page 5 UV7254
Exhibit 1
The Penny Black, the Worlds First Postage Stamp (Issued in 1840)
Source: Penny black, posted to public domain by the General Post Office of the United Kingdom of Great Britain
and Ireland, August 28, 2007, https://commons.wikimedia.org/wiki/File:Penny_black.jpg (accessed Jan. 3, 2017).
Page 6 UV7254
Exhibit 2
Cumulative Weekly Total Stock ReturnsRoyal Mail and FTSE 100 Index
35%
30%
Royal Mail
25% FTSE100 Index
20%
Cumulative returns
15%
10%
5%
0%
-5%
-10%
Jul-14
Jul-15
Jun-14
Jun-15
Oct-13
May-14
Oct-14
May-15
Mar-14
Mar-15
Feb-14
Sep-14
Feb-15
Nov-13
Jan-14
Aug-14
Nov-14
Jan-15
Apr-14
Apr-15
Dec-13
Dec-14
Source: Created by author using data from Investing.com.
Page 7 UV7254
Exhibit 3
Royal Mail Unit Volume History (Millions of Units, Period Ending March 31)
2012 2013 2014 2015

Letters
Addressed letters 15,147 13,869 13,342 13,009
Unaddressed letters 3,077 3,258 3,143 3,157
Total 18,224 17,127 16,485 16,166
Growth rate 6.0% 3.7% 1.9%
Parcels
Royal Mail core network 950 994 991 1,015
Parcelforce worldwide 66 70 77 86
Total 1,016 1,064 1,068 1,101
Growth rate 4.7% 0.4% 3.1%
Source: Company annual reports.
Exhibit 4
Royal Mail Consolidated Income Statement
(Reported as of the End of March in Millions of GBP)
2014 2015
Revenue 9,357 9,328
People costs 5,209 5,230

Distribution and conveyance costs 1,796 1,764
Infrastructure costs 1,047 1,019
Other operating costs 578 575
Transformation costs 241 145
Earnings before interest and tax 486 595
Finance costs 71 30
Finance income 4 4
Profit before tax 419 569
Tax 110 138
Profit for the period 309 431
Earnings per share 30.6 pence 42.8 pence
Source: Royal Mail annual report, 2015.
Page 8 UV7254
Exhibit 5
Royal Mail Consolidated Balance Sheet
(Reported as of the End of March in Millions of GBP)
2014 2015
Noncurrent assets
Property, plant, and equipment 1,989 1,933
Goodwill and intangible assets 392 482
Retirement benefit asset 1,723 3,179
Other noncurrent assets 55 80
4,159 5,674
Current assets
Inventories 22 20
Trade and other receivables 926 949
Cash and current financial assets 369 348
1,317 1,317
Total assets 5,476 6,991
Current liabilities
Trade and other payables 1,652 1,668
Financial loans and borrowing 286 290
1,938 1,958
Noncurrent liabilities
Financial loans and borrowings 860 559
Deferred tax liabilities 151 474
Other liabilities 126 154
1,137 1,187
Total equity
Share capital 10 10
Retained earnings 2,332 3,843
Other equity 59 7
2,401 3,846
Source: Royal Mail annual report, 2015.
Page 9 UV7254
Exhibit 6
Kyle Brookss Cost-of-Capital Analysis
TO: Hillary Hart

FROM: Kyle Brooks
DATE: July 17, 2015
SUBJECT: RMs cost of capital
Based on the following assumptions, my estimate of Royal Mails cost of capital is 3.828%.
Capital Structure
Since Royal Mail is funded with both debt and equity, I used the weighted average cost of capital (WACC) method. Based
on the March 2015 balance sheet, current debt as a proportion of total capital makes up 6%, noncurrent debt as a
proportion of total capital makes up 12%, and equity accounts for 82%:
Capital Sources Book Values (in millions of GBP)

Current debt 290 6% of total capital
Noncurrent debt 559 12% of total capital
Equity 3,846 82% of total capital
Cost of Debt
My estimate of Royal Mails cost of debt was 3.188%, which is the weighted average between the 0.9% rate Royal Mail is
paying on its current debt and the 4.375% rate it is paying on its noncurrent debt. For the noncurrent debt rate I used the
coupon rate from a recent bond. On July 29, 2014, Royal Mail issued a 10-year bond with an annual coupon of 4.375%.
The bond was rated by S&P at BBB. S&P recently reaffirmed that rating, and the bond is currently trading at a price of
106.
I used a tax rate of 20%, which is the marginal tax rate for similar corporations in the United Kingdom, to estimate the
after-tax cost of debt.
Cost of Equity
I estimated the cost of equity at 4.11% based on the prevailing dividend yield for Royal Mail. This was calculated by
dividing last years dividend of 21 pence by the current share price of 511 pence. The dividend yield is a good estimate of
the cost of equity because it indicates exactly what equity holders received over the past year on their investment.
I also looked at an estimate based on the capital-asset-pricing model (CAPM). My CAPM estimate of Royal Mails cost of
equity was 5.321%. To get this number, I used a risk-free rate of 1.551%, the average yield on the 5-year government bond
over the past 18 months. Because of the short period since Royal Mail has been privatized, there were few estimates of
beta. But recently the equity research firm Chambers and Thompson published a beta estimate for Royal Mail of 0.65, so
I used that. For my market risk premium I used 5.8%. This estimate comes from a rigorous academic survey of British
investors that was published a few months ago. However, for my estimate of the cost of equity I selected the dividend
yield estimate over the CAPM estimate because I felt it more prudent to be conservative.
Weighted Average
Based on these assumptions, my estimate of Royal Mails cost of capital was 3.828%.
WACC = Kd(1 t) D/(D + E) + Ke E/(D + E)
= 3.188% (1 20%) 18% + 4.11% 82%
Page 10 UV7254
Exhibit 6 (continued)
Comparables Estimates
To confirm my estimate I calculated the weighted average cost of capital for five comparable publicly traded companies.
My estimates were:
National Grid: 3.853%

Severn Trent: 3.136%
Tesco: 5.475%
United Utilities: 3.281%
Vodafone: 5.660%
Since the comparable estimates are in the same general range as my 3.828% estimate for Royal Mail, I felt like my estimate
was a reasonable representation of the true cost of capital for Royal Mail.
Source: Created by author.
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Exhibit 7
One-Month Interbank Lending Rate and Government Bond Yields (%)
1-Month
Bond 5-Year Bond 10-Year Bond
Jan-14 0.47 1.78 2.71
Feb-14 0.47 1.80 2.72
Mar-14 0.47 1.87 2.74
Apr-14 0.47 1.86 2.67
May-14 0.48 1.80 2.57
Jun-14 0.48 1.99 2.67
Jul-14 0.47 1.98 0.62
Aug-14 0.47 1.70 2.37
Sep-14 0.47 1.78 2.43
Oct-14 0.47 1.56 2.25
Nov-14 0.47 1.30 1.93
Dec-14 0.47 1.20 1.76
Jan-15 0.48 0.91 1.34
Feb-15 0.48 1.28 1.79
Mar-15 0.48 1.09 1.58
Apr-15 0.48 1.30 1.84
May-15 0.48 1.26 1.80
Jun-15 0.51 1.46 2.03
Data source: Bank of England Statistical Interactive Database,

http://www.bankofengland.co.uk/boeapps/iadb/Index.asp?first=yes&SectionRequire
d=I&HideNums=-1&ExtraInfo=true&Travel=Nix.
Exhibit 8
UK Corporate Benchmark Bond Yields for 10-Year Maturity in GBP (July 14, 2015)
Credit Rating Yield

AAA 2.503
AA 2.839
A 3.356
BBB 3.776
BB 4.773
B 5.883
Sources: Thomson Reuters and author estimates.
Page 12 UV7254
Exhibit 9
Financial Data for Comparables (Market Data as of July 14, 2015, Other Data is Most Recent Available)
Company Industry
National Grid Electricity and gas utility

Severn Trent Water utility
Tesco Food retailer
United Utilities Water utility
Vodafone Telecommunications
National Severn United

Grid Trent Tesco Utilities Vodafone
Price per share (pence) 855 2,190 200 900 230

Dividend per share (pence) 42 80 15 36 16
Shares outstanding (millions) 3,730 239 8,096 682 26,440
Market capitalization (millions) 31,892 5,234 16,192 6,138 60,812
Book equity (millions) 11,911 1,078 14,715 2,216 70,802
Book debt (millions) 25,950 4,622 11,213 6,042 25,362
Beta 0.60 0.79 0.87 0.67 0.86
Credit rating BBB BBB+ BB+ BBB+ BBB+
Data source: Financial Times, https://markets.ft.com/data/equities.

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UV7254

Rev. Apr. 3, 2017

Royal Mail plc: Cost of Capital

Royal Mail plc

The Cost of Capital

Source: Created by author using data from Investing.com.

2012 2013 2014 2015

Source: Company annual reports.

People costs 5,209 5,230

Earnings per share 30.6 pence 42.8 pence

Source: Royal Mail annual report, 2015.

Source: Royal Mail annual report, 2015.

TO: Hillary Hart

Capital Sources Book Values (in millions of GBP)

National Grid: 3.853%

Source: Created by author.

Data source: Bank of England Statistical Interactive Database,

Credit Rating Yield

Sources: Thomson Reuters and author estimates.

National Grid Electricity and gas utility

National Severn United

Price per share (pence) 855 2,190 200 900 230

Data source: Financial Times, https://markets.ft.com/data/equities.

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