Question

How to find CVS Health WACC, Cost of Debt, Cost of Equity using CAPM model (Capital Asset Pricing Model) for year 2017?

Answer 1

(i) Cost of Debt - We always find post tax cost of debt i.e. after considering tax shield on the interest payment since it is tax deductible. Therefore, it will be = Rate of Interest (1 - Tax Rate). For example, if company issued 10% Debentures and tax rate is 30%, then cost of debt =0.10 (1-0.30) = 0.07 or 7%.

(ii) Cost of Equity using CAPM model - This model compute return expected by shareholder if he is investing in company/already invested in the company. It consist of -

(a) risk free return (such as return on bonds),

(b) risk premium (Market return over and above risk free return).

(c) Beta  (measures volatility of stock price relative to market). Beta of 1 indicates share volatility(movement) is exactly same of market benchmark (example S&P 500). Beta greater than one indicates stock is more volatile in relation to market movements. Also Beta less than one indicates price is less volatile relative to market benchmark.

Formula - Risk Free Rate of Return + (Market Return - Risk Free Rate of Return) x Beta of the stock

For example, Risk   Free Rate of Return = 5%, Market Return = 9% , Beta of stock A = 1.30

Hence, Cost of Equity using CAPM = 5 + (9 - 5) x 1.30 = 10.20%. Here, we do not consider tax savings since dividend are not tax deductible unlike debt in the above example.

(iii) WACC - It is the weighted average cost of capital of the company using Debt and equity as their weights. The weights in the calculation of the firm's WACC are the proportion of each source of capital. It is pertinent to note that we use market value of Equity (both preferred and common) and Debt in calculating WACC and not their balance sheet  value. However, if no information of market value is provided, we may use balance sheet value assuming it represents market value.

For example, please find attached file.

Cost of preference shares will be same as the rate of dividend. This is because dividend from preference shares are not deductible in taxes.