Case Analysis - Cost of Capital
Case Analysis - Cost of Capital
What is the cost of capital? Why do Dale and Lee care about cost of capital?
The cost of capital is the required rate of return when it comes to a capital budgeting or in
investment decisions that a certain company has to deal, because as we all know the every company
need a capital or money to finance their day to day operations. It usually refers to the weighted average
of a company's funding sources, such as debt and equity, combined. In general, a firm raises funds from
a wide range of sources and then uses those funds to conduct business. A company owes its financing
providers a return on their investment. If a company only has one source of funding, its cost is the bare
minimum it would receive from the business. Many firms, however, use multiple sources of funds to
finance their operations, and their overall cost of capital is calculated using the weighted average cost of
all capital, also known as the weighted average cost of capital (WACC). Dale and Lee care about the cost
of capital because they want to know what the appropriate minimum rate is for Walmart to use as a
benchmark when making investment decisions for various projects. They may also use WACC as a
discount rate in the discounted cash flow model for valuation.
How should Dale and Lee go about estimating the cost of long-term debt?
how will they consider the tax, compute the cost of debt)
Cost of debt is the expected rate of return for the debt holder and is usually calculated as the effective
interest rate applicable to a firm’s liability. It is an integral part of the discounted valuation analysis,
which calculates the present value of a firm by discounting future cash flows by the expected rate of
return to its equity and debt holders. Basically, long-term debts can be mainly divided into two types of
debt instruments: the bonds and the long-term loans. Each type of instrument comes with different
nature and interest rate. As a consequence, the cost of long-term debt should be the weighted rate
between cost of bonds and cost of long-term loans. We can use the average yield-to-maturity (YTM) in
estimating the cost of company’s bonds. Yield-to-maturity (YTM) is the total return anticipated on a
bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield. The
reason why it is used as the cost of debt is because YTM represents the internal rate of return by
debtholder which has already concerned about the company's credit. In reality, many companies issue
more than one bond. So, the cost of bonds should be the weighted of each bond YTM which can use
bond’s face value as a weighting factor. However, this approach is only useful when the bond is publicly
traded. If the bond is not publicly traded, the cost of bond can be estimated by using the Bond-Rating
approach in which we assume that, on average, the company can issue bonds at the same rating as the
company’s overall credit rating. On the other hand, we normally use the average of historical long-term
loans interest rates as a cost of long-term loans. The average of all Walmart’s bonds YTM is approximate
to the given bond’s YTM which is 3.53% We also can assume that long-term debt of Walmart is mainly
structured by bonds.
If Walmart had preferred shares, or planned to issue preferred shares, how would Dale and Lee deal
with them?
The WACC formula is expressed as the sum of each capital's weight multiplied by its cost. A change in
the cost of debt, preferred stock or common equity, as well as any adjustment in the relative amount of
each type of capital as employed by the company can lead to an increase or decrease in the company's
WACC. So, if Walmart planned to finance the company with preferred shares, WACC must be changed in
order to reflect all costs of the company's source of funds. By adding preferred stock as another source
of fund will increase WACC and also will make tax shield less impact to the company resulting from a
decreased in debt weight. However it is essential to note that the lower the WACC, the higher the
market value of the company, in this case if there is an issuance of preference share the market value of
the company becomes lower.
Deferred taxes refer to either positive (asset) or negative (liability) entry on a company’s balance sheet
regarding tax owed or overpaid. A deferred tax liability or asset is created when there are temporary
differences between book tax and actual income tax. There are numerous types of transactions that can
create temporary differences between pre-tax book income and taxable income, thus creating deferred
tax assets or liabilities. For example, if the company calculates depreciable assets by using straight-line
method, while tax regulation allows the company to use an accelerated depreciation method, the
straight-line method produces lower depreciation compared to accelerated depreciation method. The
company’s accounting income is higher than its taxable income. As the company continues depreciating
its assets, the difference between straight-line method and accelerated depreciation narrows and the
amount of deferred tax liability is gradually removed through a series of offsetting accounting entries.
With regards to WACC, some may realize deferred tax as a source of funds that are provided by the
government and use it to calculate WACC. But what Dale and Lee should do is to not include deferred
tax in WACC calculation because the government financing is interest free. However, having deferred
tax might affect the valuation of the company’s deferred tax liabilities can be realized as firm’s future
liabilities. It would lower the value of the company as we expected to pay all of these liabilities in the
future.
How might Dale and Lee go about estimating the cost of equity? (Compute for the cost of equity using
the two methods: discounted model and CAPM)
Dale and Lee could use CAPM model in order to calculate the company’s cost of equity. The formula to
calculate cost of equity using the CAPM model is shown below:
The risk-free rate is typically equal to the yield on a 10-year US government bond. It is generally defined
as the (more or less guaranteed) rate of return on short-term U.S. Treasury bills, because the value of
this type of security is significantly stable, and the return is backed by the U.S. government. Therefore, in
this case, we used the 10-year Treasury bond’s yield of 2.65%.
The beta of the stock refers to the risk level of the individual security relative to the broader market. For
this case, we used the adjusted beta of 0.71. This is because, according to Bloomberg, the ad hoc
adjustment – 0.67 times the raw beta plus 0.33 – always makes the adjusted beta closer to the market’s
beta of 1.0. This is also for the assumption that stock return will move in correlation with the average
market return over time.
Regarding the market return, we used geometric average of S&P500 return between 2009 and 2018
which is equal to 12.98% as provided in Exhibit 5. Geometric average is appropriate in this case since it
already includes the compounding effect of the return from time to time.
With these given factors, using the formula provided earlier, the cost of equity is equal to 9.98%.
Besides the CAPM model, we can also compute the cost of equity using the Discounted Model. In order
to compute the cost of equity, we can forecast expected dividends yield by looking at its historical data
in Exhibit 4. The formula for the Discounted Model or Dividend Discount Model (DDM) is Re = Dividend
Yield + g
Thus, given the dividend yield of 2.16% and growth rate of 0.78%, the cost of equity is 2.49%.
What is the overall weighted average cost of capital? (Discuss your computation and the basis of your
capital structure)
A company raises funds from different financial sources and uses those funds in doing business.
Consequently, the company has a responsibility to give a return to its funding providers. If a company
has only one source of financing, then it is the rate at which it is required to earn from the business.
However, in this case the company has debt and equity as sources of funds in which case WACC
(Weighted Average Cost of Capital) must be found. WACC indicates the minimum rate at which the
company should earn from the business in order to give a return to its finance providers, as per their
expectations and can be computed using the formula below.
First we’ll have to compute for the equity’s market value which is calculated by multiplying the common
shares outstanding with the current market share price. Given the common shares outstanding of 2,945
and the current market price of 102.20, the equity’s market value is 300,979.
The debt’s market value is considered to be more complex than the market value of equity because
some type of debt might not be publicly traded. For instance, the company may issue non-publicly
traded bonds or make loans from the bank. However for this case, we assumed that the company's book
value of debt is approximately equal to market value.
In this case, short-term borrowings and long-term debt are both considered to be company’s interest-
bearing debt. We decided to average total interest-bearing debt between 2018 and 2019 and use the
result, 52,260 to represent the market value of the company's interest-bearing debt.
After computing the market value of both debt and equity, we derived the market weight of equity of
0.85 and market weight of debt of 0.15.
For the cost of debt, we calculated it by weighting the cost of short-term borrowings and cost of total
long-term debt. The result is a cost of debt which is equal to 3.45% and with these, the following
assumptions must be made:
2. Long-term debt & Capital leases are dominated by bonds and average bonds YTM is equal to the
given YTM.
Given the cost of equity of 9.98% computed earlier, together with the key inputs, the WACC of the
company is estimated to be 8.89%.
How does all of this relate to hurdle rate that Walmart might use?
Hurdle rate, also known as minimum acceptable rate of return (MARR), is the minimum required rate of
return or target rate that investors are expecting to receive on an investment. The rate is determined by
assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return
for similar investments, and other factors that could directly affect an investment.
Most companies generally use their weighted average cost of capital (WACC) as a hurdle rate for
investments. This is because companies can buy back their own shares as an alternative to making a new
investment, and would presumably earn their WACC as the rate of return. In this way, investing in their
own shares (earning their WACC) represents the opportunity cost of any alternative investment. This
would also mean that WACC is seen as a benchmark required rate of return by investors. Thus, before
accepting and implementing a certain investment project, its internal rate of return (IRR) should be
equal to or greater than the hurdle rate.
For risky projects, hurdle rate tends to be higher due to risk premium compensation. Therefore, the
more risky the project is, the higher hurdle rate would be and vice versa. An appropriate hurdle rate is
equal to the weighted average cost of capital plus the project risk premium.
In conclusion, the appropriate hurdle rate that can be used for Walmart is the WACC because it is
considered as the minimum required rate of return that the company must provide for its investors.
However, it is also important to consider adjusting the appropriate hurdle rate by its risk premium for
projects that are considerably risky.