Guaranteed Higher Grade!

Free Quote
Estimating Weighted Average Cost of Capital for an Actual Corporation

Objective

This is a guideline and is not meant to show you exactly step-by-step how to do the project (although it comes close to doing that). In the “real world”, your boss is not going to show you how to do everything. She is going to ask you to do something and you are going to have to do it to the best of your ability. Supplement this document with things we discuss in class when I review the project, google searches, STU library resources, etc. If you are totally stuck

The assignment is to estimate the weighted average cost of capital (WACC) for an actual corporation as of the current time. Actual managers would need to know their company’s WACC as a starting point to estimate the discount rate to use in the net present value analysis of new projects (or of termination decisions). You may need to know the technique for application in some case study solutions.

The project also develops student skills in using elementary financial management models, in dealing with situations where there are too much or too little data, in employing publicly available data sources with little guidance, and in applying sound judgment when encountering naturally occurring measurement errors. Rubric

The project is scored out of 100 points. It is worth 10% of your total grade. Grading will be strict: follow the guidelines for a “good” grade.

15 points: Clear presentation of the data needed to estimate the WACC.

25 points: Avoiding major errors that renders your WACC estimate useless. This includes recognizing when a certain method of estimating the cost of capital for a financing source is not correct.

60 points: The totality of the rest of your project, including all of the components, and following the directions outlined in this document.

Details

1. Your report will have no extended textual part; i.e., no long paragraphs.

2. Your report should include supporting data, such as snipped pictures from the internet.

3. An important feature of your submission is defending your assumptions. For example, if you use a risk premium of 7% when calculating the marginal cost of equity using the risk premium method (i.e., Ke = Kd + risk premium method), explain your reasoning in a few sentences.

Picking Your Corporation

1. Each person should pick a different corporation. This is not a group project.

2. The corporation must be a publicly traded company. Many well-known companies are not publicly traded. For example, Publix, Albertson’s, Deloitte are private companies and cannot be used for this project.

3. Avoid public utilities (FPL, telephone companies, etc.) Because of regulation, their WACCs have a different meaning.

4. Avoid financial companies (banks, insurance companies, brokers, etc.). Because of regulation, their capital structures are difficult to discern.

5. Your corporation must have common equity and long-term debt (debt with maturity dates of more than 1 year).

The Primary Equations

The theory of why managers should use the WACC in net present value analysis comes later in the course. For now, start with the equations for WACC, per se:

ka = (E/V)*ke + (B/V)*kd*(1 – t)

V = E + B

ka is the required rate of return on the firm’s assets, which is the same as WACC.

ke is the firm’s marginal cost of common equity.

kd is the firm’s marginal cost of debt.

V is the total market value of the corporation. (not explicitly in the textbook)

E is the market value of outstanding common equity.

B is the market value of outstanding notes, debt, bonds, debentures, mortgages, and other interest-bearing securities.

• For this project, estimate “B” by using the (total debt – current liabilities) from the most recent balance sheet. Even though this is not a market value, in practice the book value of debt is generally much closer to the market value of debt, especially when compared to book value of equity vs. market value of equity.

It is the marginal tax rate the firm faces. Given the new tax code, use t = .21 for your project.

1. Estimate the Marginal Cost of Debt

Marginal Cost of Debt: This is an estimate of the interest rate the corporation would have to pay on new borrowing.

Method 1: Try to find the yield to maturity on your firm’s long-term debt. Try google and see what you find.

Method 2: Try to find your corporation’s Standard and Poor’s issuer debt rating. Again, try google. Then look on page 205 in your textbook at the table and estimate an appropriate rate. For example, if you find the rating is “AA-“, which would fall between AA and A, you may decide to choose 4.5% (which is between the 4.40 %and 4.62% in the 25-year section)

Method 3 (optional): If method 1 and 2 provide nothing, first double check to make sure your firm has long-term debt, and then follow steps 1 and 2 for a close competitor of your firm, and then make a judgment call on a estimate of Kd for your firm. If the rating is junk [BB, B, and CCC], you have to creatively add a premium to the BBB interest rate.

Method 4: kd = rf + premium

In this method, add a premium to the risk-free rate (Rf). (See below for how to obtain Rf). You can use information from page 205 to guide you. For example, let’s say you did not find your firm’s issuer credit rating, you can make an educated guess of what it would be, and then add an appropriate premium to Rf. For example, if you guess the credit rating should be an A, the difference in the 25-year row of page 205 is 1.81 percentage points (4.62% - 2.81% for the Treasury). Take the Rf rate and add 1.81% to it for your estimate of Kd. A note on Rf:

Experts disagree on what to use to the first riskfree rate, rf. Pure theorists insist on the Treasury Bill rate; November 30, 2009 reveals this datum to be 0.0005. Some pragmatists recommend that since the CAPM uses annual rates, rf should be the one-year rate of about 0.0040. Pure pragmatists argue that since WACC is used to judge long-term projects, rf should be the longest T-Bond rate. Still others argue that a T-Note is best. I suggest you use the “^TYX”, which is the long-term bond rate. Go to Yahoo Finance and type in ^TYX in the symbol field. The number that is shown, say 2.95, implies Rf is 2.95%.

Please Remember

You now have several estimates of Kd for your firm. Pick a final estimate and justify it for your final calculation.

2. Marginal Cost of Equity A description of the marginal cost of equity, ke, is the anticipated, long-run average rate of return on the current stock value necessary to maintain the stock price at its current level. The rate of return is from both dividend yield and capital gains. There are many methods for estimating ke; I present the best three available.

Method 1: The Risk Premium Method An investor can earn a relatively low-risk return of kd via your corporation’s debt. In order to persuade the investor to buy your corporation’s riskier equity, the investor must expect a higher return, ρremium. Thus,

ke = kd + ρremium

Here, ρremium, is a subjectively estimated risk premium: given that an investor in your corporation can with some safety earn kd investing in debt, how much more should the investor expect to earn from investing in your corporation’s risky equity? Experience has shown that ρremium ranges from 0.02 to 0.10.

For the firm you have chosen, think about the nature of its business operations. Make a subjective assessment of the risk (and defend it in your project) and add a premium.

Method 2 The dividend capitalization or Gordon model

ke = (D1/Po) + g

In this model, D1, is annual dividend per share that is expected to be paid next year, Po is the current common stock price, and g is the anticipated growth rate of dividend far into the future. To estimate g, go to Yahoo Finance

a. Enter your company’s ticker symbol in the search bar near the top and click search or enter.

b. Click Historical data

c. Change the time period, type of data, and frequency to the following, and then click “Apply”

d. Add up the first 4 (quarterly dividends shown). Add up the bottom 4 quarterly dividends shown. Then find the annual compound growth rate.

• For example, when I did this for ticker symbol ABC, I had .38 as each of the 4 most recent quarterly dividends, which is $1.52. For the bottom

4, I had .235 each, which comes to .94.

Using the financial calculator to find I/YR (or our potential estimate for g in this exercise), I

N = 4

I/YR = ? =

PV = -.94

FV = 1.52

PMT = 0

I/YR = 12.76, or 12.76%. This is way to high for an annual growth rate to persist forever, as is needed to apply the Gordon constant growth model, so I will not use this method to estimate Ke.

Method 3: The Capital Asset Pricing model

ke = rf + β(market risk premium)

Rf we discussed above.

There are many Internet sources for beta, β, the measure of how volatile your stock price is relative to the market as a whole. The estimates are likely to differ because of differing assumptions used in the beta calculation. Use the estimate 4rom Yahoo! Finance. Type in the symbol, and on the summary page, Beta is right there.

For market risk premium, we apply a pragmatic approach. Professor Pablo Fernandez communicated with hundreds of Finance professors worldwide and reviewed 150 textbook recommendations. His conclusion is that the 0.057 is a recent best estimate of the market risk premium, rm – rf. Please use this figure.

Note: Many times β is low or even negative. Plugging the low beta in often will yield a marginal cost of equity estimate that violates ke > kd. Other situations have arisen where β is unreasonably high — a beta value of 19 yielded a ke over 200%. You might find a negative β that will give you an unreasonably low ke estimate. Many essentials of finance textbooks imply that the CAPM cannot fail as an estimator. It is a valuable tool for estimating ke, but, as you see, using it does involve subjectivity and it can yield unsatisfactory estimates. Use your judgment!

You now have several estimates of Ke for your firm. Pick a final estimate and justify it for your final calculation.

Estimate the Value of Each Kind of Capital

1. Equity

The easy one is equity. It’s simply:

E = price per share x number of shares outstanding

A good one is Yahoo! Finance. Type in your firm’s symbol and look at marketcap on the Summary tab. That is the answer.

2. Borrowing

(Total debt – current liabilities) from the most recent balance sheet. Go to Yahoo Finance

Financials Balance Sheet to find this.

3. Find the Total Corporate Value

V = E + B

Apply equation [1]

ka = ke(E/V) + kd(1 – t)(B/V)

Recall, t = .21 now.

1. The “weights” for each source of capital must total to 1.0 — if they don’t, you made an arithmetic error. If you get something close, like 0.999 or 1.001, don’t worry about a small rounding difference.

2. The ka must be less than the ke and more than kd(1 – t). If it isn’t, you made an arithmetic error in equation [1] or [2].

3. Look out for situations where you find data in one source stated in millions and data in another source stated in just dollars, for example. If you don’t rectify the dollars to a consistent level of significance, you’ll get a silly answer.

4. Do your component cost of capital work in decimal fractions to avoid mixing percentage figures with decimal fraction numbers. Here is a valid calculation for Black & Decker CAPM equity capital cost estimate:

ke = 0.0454 + 0.998(0.0499) = 0.0952 = 9.52% Good!

Now suppose the student uses the T-Bond rate of 4.54% improperly:

ke = 4.54 + 0.998(0.0499) = 4.59 = 4.59% = ridiculous