What Is the True Significance of WACC for a Company - Case Study Example

Part When considering a capital investment project a business must carefully assess the average return required by the firms investors in order to determine the required interest rate of the market and consequently the companys cost of capital. For the typical investor, its is in their best interests for the business to minimize its cost of capital in order to maximize the firms overall profitability while ensuring the equity value of the firm does not suffer. For the corporate finance manager the process of identifying and minimizing financing cost is one of their main responsibilities. The weighted average cost of capital (WAAC) of a specific firm is the calculation of the companys total capital costs, where each of the sources of financing is proportionally weighted. In other words; the WACC uses the weighted average all of the businesss capital sources such as common stocks, preferred stocks, bonds, stocks, loans and any other direct costs related to financing activities in order to determine how much each additional dollar of financing is actually costing the business as interest. Generally all of a companys real assets are purchased by either debt or equity sources of financing (Besley & Brigham, 2000). What is the true significance of WACC for a company ? For both equity holders and lenders, the expected rate of return on their investment dollars is the most important factor and the WACC provides the right answer for both shareholder and debt holders. By knowing the WACC, a firms management can use it to maximize the efficiency of their cost structure by allocating their financial resources with a goal lowering their overall capital costs. By minimizing their capital costs a company can help maximize their overall equity valuation, lower operating risks and help meet or exceed the expected rate of return for their specific business investment. As a practical example, if an investor is evaluating a business as a possible investment with a WACC of 12%, and is generating consistent returns of 16%, the wealth of the firm will increase by 4% after completing the project. Therefore, the WACC of a company provides an educated investor with a tool to evaluate and maximize the return of a well diversified portfolio (Investopedia, 2014). WACC and How is it calculated? For an investor the cost of capital is defined as “the opportunity costs of all capital invested in an enterprise”.Therefore, the importance of the WACC calculation as an investment tool for the educated or institutional investor must not be underestimated. The typical firm will have both debt and equity sources for their capital financing needs. In order to calculate the weighted average cost of capital of any company we follow a general three step process: I) Calculate the individual costs of each capital component. II) Determine firms capital structure III) Weighting the components I) Calculate Capital Costs Components 1) Cost of Debt- Some firms choose to raise the funds needed for a capital investment project using only equity sources of financing, but most will obtain a significant portion of funds from long-term debt for their capital investment projects due to capital budgeting decisions and to lower their borrowing costs. As far a debt financing, companies have the choice of using loans, issuing new bonds in order to satisfy their capital needs. In general terms, most companies prefer to use bonds instead of loans as a source of debt financing due to the increased financing flexibility for both the banks and the issuer as well as generally offering lower borrowing costs compared to a similar long-term loan. It is worth mentioning that although preferred stocks are technically a form of equity financing, they are a sort of hybrid of equity and debt instruments so they are sometimes used in lieu of issuing new bonds. Since preferred stocks have a fixed par value and pay dividends solely as a fixed percentage of par, they share a lot of characteristics with common bond debt financing (Investopedia, 2014). Calculating the cost of debt is a fairly straightforward procedure either loans, bonds or even preferred stocks. The applied rate on the principal of the debt instrument (or preferred stock) represents the cost of debt as stated in percentage. If the current interest rate paid by the firm for their debt is not readily available, it can be calculated utilizing the companys financial statements. In the case of many publicly traded companies, the average interest rate for all debt instruments will be implied in their financial statements. By utilizing the total interest expense for all debt financing, and dividing it by the total amount of debt for the period, we can then express the cost debt as a percentage. The total cost of debt or the companys effective rate is expressed as a percentage as either before tax or after-tax. When a firms tax expense is tax-deductible, the after-tax rate approach is preferred since it will lead to a lower cost of debt for the business (Nyu). For example: Bonds or Loans; If a company decides to issue a bond at a 8% interest rate and the effective tax rate for the business is 40%, What is the true cost of the debt for the issuer? Formula: Ei = Effective after- tax interest rate Interest rate (1-Tax%) = Ei 8%(1-.40) = 4.8% Preferred Stock; A preferred stock is selling at $80 per share and has $1.75 annual dividend payout per share. The company has to incur 3% in origination costs (OC), per share sold. What is the effective cost per share? Formula: (Dividend$/Price per share)(1-OC) = Cost per share% 2/80(1-.03) = 2.43% 2) Cost of Equity For a company the cost of equity represents the amount of return a stockholders requires to invest their capital in your firm. The average shareholder expects a certain level of return for their equity ownership in order to economically justify their investment. Internally for the company, the cost of equity also represents how much it will cost to the business to maintain share price at a price level where it is satisfactory to their current and future investors. Unlike debt instruments which carry a par or face value, the cost for equity instruments is harder to calculate since share price varies based on the constant flux and inherent volatility of the investment markets. As for the typical investor a companys cost of equity provides a valuable window into the inner workings of the company and how risky the market perceives this particular stock as an investment. For any corporation, a high cost of equity is a clear indicator that the market visualizes the company as a risky investment, thus requiring a greater return on investment to justify the added investment risks Therefore, for any company it is imperative to maintain a low cost of equity due in order to maintain their equity value and lower costs of capital. Based on these premises, the commonly accepted Capital Asset Pricing Model (CAPM) of equity valuation, provides the most accurate method of calculating equity costs. In simple terms, the formula for capital costing using the CAPM approach is (Business-case-analysis, 2014): Capital Asset Pricing Model = (Equity Market Risk Premium) X (Beta of chosen equity)+ Risk-free interest rate Lets analyze the components of the CAPM and what they each mean (Investopedia, 2014): Equity Market Risk Premium(EMRP)- It represents the average return an investor expects over the risk-free market rate, when taking into consideration the added risks associated with the average stock investment. The market risk premium commonly provided online is based on a running historical average of the stock market returns over the risk-free interest rate. For an average company, the stated EMRP is close enough to reality to be used in the WACC calculations (Nyu). Beta- The company beta is a measure of the riskiness of the firm. The beta coefficient gauges how much the share price of the company reacts against the average return of the stock market as a whole. For example a beta of 1, indicates that when compared with the movements stock market the company reacts proportionally in line with the markets behavior. A beta of more than 1, indicates that share price will react in a way that amplifies the normal markets movements. Consequently, a beta of less than one indicates decreased sensitivity to market flux if compared with an average stock (beta of 1). For publicly traded companies there are numerous database services (Reuters.com, Yahoo-Finance) which provide free up-to date beta coefficients of many publicly traded companies. Risk-free interest rate- The risk- free interest rate represents the portion of the return on investment investment which could be obtained if the investor bought securities free of credit risks, such as U.S. Treasury bonds, or any other developed country security. The interest rate of U.S. Treasury bills is commonly used as reliable measure of the risk-free interest rate. II) Determine the firms Capital Structure In this step we must calculate the proportion that each type of debt and equity instruments is used from the total available capital for the company. III) Weighting the components We must calculate what the weighted average cost % is by calculating the proportion that each type of debt or equity capital contributes to the total available capital. After determining the cost of equity and debt, capital structure and weight of each component we can apply the general WACC formula (Wilkinson, 2013): Legend: Prop. = Proportion, Preferred Stock = PS, Common Equity = CE WACC = [(Prop. of Debt)(After-Tax cost of debt)] + [(Prop. of PS)(Cost of PS)] + [(Prop. Of CE )(Cost of CE)] Part 2 ( see Appendix 1) Burberry Group PLC, is a luxury brand apparel and outerwear company with a distinctly British identity established in 1856, and incorporated in October 30,1997.The company designs,sources and markets luxury accessories and outerwear for men,women and children internationally. The company uses a network of retailers,franchisees and wholesalers to market their product lines. We chose the publicly traded outerwear company Burberry Group plc in order to demonstrate WACC calculation. We will calculate the result for each of the components and use the WACC formula to calculate the average cost of capital for Burberry in 2013 and 2014. Cost Of Capital Components Cost of Debt- By analyzing at Burberrys annual report we can look into the Balance Sheet section in order to find out the amount of long-term debt and interest expense for the firm in 2013 and 2014.The amount of reported long-term debt of Burberry as of Mar.31,2013( in millions) was 108 £m and 107.4 £m for 2014.The firm reported an interest expense of 3.7 and 3.2 £m accordingly. By dividing the companys interest expense by its long term debt for the year we can calculate a cost of debt of 3.43% for 2013 and 2.98% for 2014. Cost of Equity- By using the Capital Asset Pricing Model formula,we can estimate the cost of equity of Burberry Capital Asset Pricing Model = (Equity Market Risk Premium) X (Beta of chosen equity)+ Risk-free interest rate Equity Risk Premium- There are numerous websites which provide the average equity market premium. By running a historical average of stock market returns over the risk-free interest rate the websites can calculate what the average risk premium is for the stock market. The reported equity market risk premium as of November 1,2014 was 5.14%(Nyu). Company Beta – The reported company Beta for Burberry,LLC by reuters.com is 1.23 Risk-free interest rate – By looking at the forward looking 1 year Treasury Bill table, we can estimate an average risk-free interest rate of 3.7%. We can now calculate the Cost of Equity using CAPM: (.0514) x (1.23) + .037 = 10.02% II) Determine the firms capital structure Burberry had the following amount of Debt and Equity capital as of 11/14/ 2014: Equity Capital Debt-Capital Outstanding shares 220 million shares Market value per share $44.86 Total Capital Value 9,869.2 £m 107 £m III) Weighting of Components By dividing the proportion of each kind of capital(debt or equity) by the total available capital,we can calculate the proportion(%) of each. Equity Debt Total Capital 9869.2 + 107 = 9,976.6 £m Proportion of Equity-Capital = 9869.2/9976.6 = 98.92% Proportion of Debt-Capital = 107.4/9976.6 = 1.02% Calculating the WACC for Burberry We have calculated the components of the WACC costing approach,we are now ready to calculate the WACC for Burberry. Since the company does not have any preferred stocks,we can eliminate that part of the formula. WACC = [(Prop. of Debt)(After-Tax cost of debt)] + [(Prop. Of CE )(Cost of CE)] For the year 2013: WACC = [(.012)(3.43)] X [(.982 )(10.02)] = 10.41% For the year 2014: WACC = [(.012)(2.98)] X [(.982 )(10.02)] = 10.36% The weighted average cost of capital of Burberry was 10.41% for 2013 and 10.36% for 2014. Conclusion Burberry Group,has been successful at using a capital structure virtually void of using debt capital,unlike many of their competitors which rely heavily on debt for their capital needs. As a luxury retailer,Burberry enjoys a low Cost of Equity of 10.02% and a WACC of only 10.36% for 2014, allowing the firm to maximize the efficiency of their capital structure. With a Return of Equity for 2014 of over 29% the company has been utilizing their equity resources very efficiently,therefore maximizing their growth and bottom line. As a luxury retailer,Burberry has been able to maintain a level of healthy growth, increasing revenue from under 2.0 B gbp to over 2.3B gdp for 2014.Although their overall cost of goods and SGA expenses increased as a percentage of sales,the firm was still able to increase their overall net-income, maintain a low WACC,all while keeping virtually a no debt-capital structure. References Besley, S., Brigham, E. (2000). Essential of Managerial Finance (12th ed.). Fort Worth: The Dryden Press. Burberryplc.com (2014). Burberry Plc 2014 Annual Report. [Accessed 14 November 2014] Business-case-analysis.com (2014). Cost of Capital, Cost of Borrowing, and Similar “Cost of” Terms Explained. [Accessed 16 November 2014] Investopedia.com (2014). Complete Guide to Corporate Finance. [Access 16 November 2014] Investopedia.com (2014). Cost of Capital – Cost of Debt and Preferred Stock. [Access 16 November 2014] Investopedia.com (2014). Cost of Capital – Cost of Equity. [Access 27 November 2014] Nyu.edu. The Weighted Average Cost of Capital. [Accessed 16 November 2014] Nyu.edu. Damodaran online. [Accessed 16 November 2014] Wilkinson, J. (2013). Weighted Average Cost of Capital (WACC). [Accessed 16 November 2014] Read More