Question

11a. Why do some companies have lower WACC estimates than other companies? (page 372)
11b. How could someone come up with significantly different WACC estimates? (page 372)
11c. Using the following information, calculate the CAPM cost of equity for WMT. (pages 365 and 372)
Risk-free rate (10-year Treasury as of Dec 2019)						1.9%
Market risk premium (Investopedia December 2019)						5.4%
Beta						0.38
Walmart CAPM cost of equity estimate							(Solution: 3.95%. Compare to 6.22% on page 372)
12. This is an example of using the Dividend yield plus growth rate model to estimate the cost of equity and use that estimate to value company stock. If a company has a low cost of equity, it means shareholders expect a low return on its stock, and it allows the company to take on lower-yielding, lower-risk projects. However, a company should not have a cost of equity below the risk-free rate, so if a company has a negative 3-Year EBITDA growth rate, that does not mean its cost of equity is negative. Investors still expect a positive return. It just means this method of estimating the cost of equity is not appropriate for that company. Get the dividend yield and 3-year growth of EBITDA (earnings before interest, taxes, depreciation and amortization) for the companies shown below by going to the Summary (opening) tab at www.gurufocus.com. Refer to the Dividend-Yield-Plus-Growth-Rate model on page 366 of your textbook for more details.
			KO	AAPL	WMT	SO	MCD
12a. Dividend Yield %
12b. 3-Year EBITDA Growth Rate
Dividend yield plus growth rate cost of equity			0.0%	0.0%	0.0%	0.0%	0.0%
12c. Based on the cost of equity estimates, which company has the highest cost of equity, and which company has the lowest cost of equity?
12d. How can this analysis be used to make an investment decision?

Answer 1

Q-11)

a) The weighted average cost of capital for a company is dependent on many factors like the cost of the sources of funds, the weight of each source, the creditworthiness of the company, future growth potential and the overall risk of the company. If the company has high creditworthiness in the market then it can raise money from the market at lower rates and the WACC would be lower but if its creditworthiness is not very good then to attract investors it will have to pay more and the WACC will rise. Similarly, the growth prospect of a company is very important, if the high has high growth potential then it can attract large capital at lower rates and WACC would be lower.

b) The calculation of WACC requires estimate like cost of each sources of funds and weight of each sources of funds. The cost of equity can be calculated from different methods and the cost will vary slightly, similarly the cost of debt with different methods will also vary slightly. The weights in the calculation can be book value weights or markets value weights, different method will give different WACC. So, the difference in WACC estimation is because of the different approach used by the analyst who is calculating.

c) The cost of equity according to CAPM

Risk free rate + beta* Market risk premium

= (1.9 + 5.4*0.38) = 3.952%