Computation of Companys Equity Cost of Capital and WACC - Essay Example

Computation of company’s equity cost of capital and WACC Cost of equity can be defined as the minimum rate of return that a company must generate andoffer to their investors in order to provide a return for their investment and for assuming some level of risk. If the company does not offer this risk to the investors there is a chance that the shareholders might shares these shares in the market. Selling of the company shares can be interpreted as a negative sign for the financial outlook of the company and will put a downward impact on the market value of the company. Cost of company’s equity can be calculated through ‘Capital Asset Pricing Model’. The formula for the capital asset pricing model is as follows. Ke = Rf + (Rm-Rf) x Beta Where Ke is the cost of the equity, Rf is the risk free rate which is usually the 10-year treasury bill rates as issue by the United States Government. (Rm-Rf) is the risk premium rate and beta can be defined as a measure of how much the stock and market move together. The following values have been traced through relevant financial sources Factors Values Rf 1.89% (Rm-RF) 5.70% Beta 0.74 Substituting the above value we get the cost of capital of Heartland Express as 6.11% WACC or the weighted average cost of capital is the weighted average cost of the company’s equity and long term debt. WACC is calculated by multiplying the cost of equity with the market value of the equity and cost of debt with the market value of the debt. Cost of debt is usually the interest rate that the company’s pay on its long term and short term financial borrowings. However, an analysis of the company’s financial statements will show that the company does have any long term or short term interest bearing financial debts. All of its debts comprise of trading nature and the company does have to pay any interest on such securities. Does the cost of debt for the heartland express is nil. Keeping all the above factors into consideration, the WACC of heartland express is equal to its cost of equity i.e. 6.11% Estimate of the equity value of the company The estimated value of the company’s equity is calculated by discounting the free cash flow of the company for the foreseeable future using the weighted average cost of capital of the company (WACC). Free cash flow method is basically a measure of financial performance of the company which is calculated as free cash flows minus the capital expenditure. From pure financial management’s perspective, free cash flow can be defined as the cash which the company is able to generate setting aside the money required to maintain or expand its current asset base. The following table presents the free cash flow calculation and the equity value of the company as at financial year end December 31, 2010. Financial Year $ in thousands 2011 2012 2013 2014 2015 2015 onwards Projected Net income (Note 1) 77,674 90,483 104,444 119,661 136,248 Non Cash items (Depreciation/Amortization) (Note 2) 65,816 70,354 75,300 80,691 86,567 Working capital adjustments (Note 3) (25,275) (25,275) (25,275) (25,275) (25,275) Capital Adjustment (Note 4) (73,419) (73,419) (73,419) (73,419) (73,419) Free Cash Flow to Firm (FCFF) 44,796 62,142 81,049 101,658 124,120 Grows at 1.5% till perpetuity (Note 5) Discounting Factor (@ 6.11%) 42,217 55,192 67,839 80,189 92,270 901,784 Total Market value of equity 1,239,490 Note 1: The projected income is included based on the figures calculated in the section ‘Revenue forecast for the period’. Note 2 Financial Year $ in thousands 2011 2012 2013 2014 2015 Projected operating cost (total of variable and fixed cost) (433,572) (463,464) (496,046) (531,560) (570,270) Estimated Depreciation (65,816) (70,354) (75,300) (80,691) (86,567) Note 2: In the free cash flow method, the depreciation and amortization expense are added to the profit after taxes since these are the non-cash items. For the financial year ended 2010, the depreciation expense for the year was $61,949 thousands which amounts to 15.08% of the total operating cost of that year which is $408,067 thousands. It is assumed that the depreciation will follow the same pattern of being 15.08% of the future operating cost. The future operating cost has already been calculated above. Note 3 Financial Year $ in thousands 2010 2009 2008 2007 2006 2005 Total current assets 193,786 124,514 138,628 277,918 410,675 363,507 Decrease / (Increase) from prior years 69,272 (14,114) (139,290) (132,757) 47,168   Average (A) (33,944)     Total current liabilities (48,900) (47,054) (104,696) (95,372) (116,423) (92,244) (Decrease) / Increase from prior years (1,846) 57,642 (9,324) 21,051 (24,179)   Average (B) 8,669 Average capital expenditure C=A+B (25,275) Note 3: It calculates the working capital adjustment to the free cash flow of every year. In order to do so, the historical pattern of working capital is observed and an average is calculated. It is assumed that in the foreseeable future, the working capital requirement would be equal to the average figure calculated. Note 4 Financial Year $ in thousands 2010 2009 2008 2007 2006 Opening PPE (413,564) (389,561) (370,358) (344,324) (281,711) Depreciation 61,949 58,730 46,109 48,478 47,351 Closing PPE 386,188 413,564 389,561 370,358 344,324 Capital Expenditure 34,573 82,733 65,312 74,512 109,964 Average 73,419         Note 4: The capital expenditure is also deducted from the free cash flows to the company. Capital expenditure is calculated by observing the historical movement in the Property, Plant and equipment ledger. An average of the historical capital expenditure is calculated and is assumed that the future capital expenditure will follow this pattern. Note 5 $ in thousands Free cash flow at the end of financial 2015 124,120 Growth rate 1.5% Discount rate 6.11% PV at 2015 of the foreseeable FCF (calculated using the constant growth model) 2,732,804 PV at year 2011 (discounting the cash flows at 31.94%) 901,784 Note 5: The free cash flows after year 2015 is calculated by assuming that they will grow at the rate of 19% in the foreseeable future. The growth rate of 19% is calculated through compound interest formula (S=P (1+i) ^n) by comparing the free cash flow of the financial year 2011 and 2015. The present value of the company’s free cash flows are calculated using the constant growth model using the following formula Present Value = Free cash flow at 2015 x (1+growth rate) Discount rate - growth rate The present value of free cash flow is then discounted to the year 2011 by using the compounding interest formula. The total value of the company’s equity is $ 1,239,490 thousands. The following Websites have been used [1]http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2011 [2]http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1805852 [3] http://finance.yahoo.com/q/ks?s=HTLD+Key+Statistics Read More