In 1968, Kennecott Copper Corporation made a hasty decision when it purchased Peabody Coal Company. In the years preceding the acquisition, Kennecott had experienced wide swings in its profitability, which it was looking to offset by diversification. Investing in another company in a different industry was an intelligent decision; however, Peabody was the wrong company to do this with.
Although Peabody had been profitable and stable over the past few years leading up to the acquisition, the internal rate of return related to the investment was not high enough to justify a purchase of the company. Peabody's cost of debt was .038. This was calculated by assuming a 40% tax rate and .095 rate on debt (Exhibit 3). There was a .095 interest rate on notes payable due June 30, 1998; therefore, we assumed the rate of debt at the time of purchase would have been similar. Also, Peabody's cost of equity was .1397. This was calculated by using a risk-free rate of .055, which was the rate of the 90-day T-bill in 1968. …
