# The Weighted Average Cost of Capital

## Reasons and implications for Kellogg’s WACC change

The Weighted Average Cost of Capital is computed by inputting the relevant figures in the formula below. The investor assumes the market value of equity and debt to be the values presented in the 2013 financial statements. The value of debt excludes short-term borrowing. The cost of debt and equity are determined first. Since tax is incorporated in the cost of debt computations, the investor ignores the final part of the WACC formula. The reasons for the change in Kellogg’s WACC are similar to the reasons given below for the differences in WACC in the four companies (i.e. Savola, Agthia, Nestle, and DANONE). One of the major implications for the increased WACC is that Kellogg’s will pay more for the acquisition of debt and equity in 2014.

## Reasons for the cost of capital differences in the four companies

The four companies have different WACC values as indicated in the attached Excel file. The following are probable reasons why their WACC values are different. The reasons emanate from the process of determining WACC.

## Determination of the Cost of Debt

Debt capital refers to what a company has borrowed to help finance its investments. It appears in the balance sheet under ‘long-term debt’. Debt issuers expect returns in the form of interest. Interest is the charge to the company for using their funds. Interest is quoted in percentage form (Bodie 97).

However, since interest is a deductible expense for taxation purposes, debt reduces the amount of tax a company effectively pays. Therefore, to determine the cost of debt, we must consider both the interest rate charged by the lenders and the corporate tax rate charged by the government (Perold 9).

## Determination of the Cost of Equity

Cost of equity refers to the returns expected by the owners of a company. Shareholders are the owners of a company and they expect compensation for providing capital. Compensation is usually in the form of dividends. The most acceptable method of determining a company’s cost of equity is the CAPM method, which considers several variables in order to arrive at the cost of equity.

## Capital Assets Pricing Model (CAPM)

CAPM financial model is used to compute the expected returns on security. CAPM can be used to determine the cost of shares, hence equity. CAPM incorporates both the risk created by investing over a period and investing in a specific security. The CAPM formula incorporates all these elements (Levich 97).

### Expected Rate of Return on a Security

It refers to the result of the CAPM formula. It represents the compensation expected by shareholders for investing in certain shares. It is composed of the risk-free rate, asset beta, and expected market returns. The figure varies from company to company.

### Risk-Free Rate

A risk-free rate is the expected return on security with no inherent risk, such as a government bond. Government bonds are taken as proxies for risk-free securities because the risk of default in payment is very low, unlike corporate bonds that are prone to default depending on the company’s financial status. Risk-free rates are different in various locations hence the differences in WACC.

### Beta Coefficient

Beta is a measure of the riskiness of the security. It is determined by the business risks facing a company and its environment of operation. Companies operate in environments that are prone to change. The beta coefficient incorporates such risks. Any beta coefficient higher than one indicates that the security in question is riskier than the market. Conversely, coefficients lower than one indicates securities less risky than the market. As the attached Excel file shows, these figures are different in the four companies.

### Expected Return on the Market

Every stock market has an average return it is expected to produce in a year. This return depends on the portfolio of securities in the market. In the case of the four companies, the expected return on the different Stock Exchanges they are listed is used in the CAPM formula. Hence, it is part of WACC.

The market risk premium is the difference between the risk-free rate and the expected rate of return on the market. It represents the amount an investor expects to be compensated for putting funds into that particular securities exchange. The four companies operate in four different stock exchanges. Since this premium affects WACC, differences are expected (Fama & French 33).

## Determination of the Weighted Cost of Capital

The Weighted Average Cost of Capital incorporates both equity and debt capital. Each type is considered depending on its proportion in the total capital mix. More debt than equity in a company could be attributed to the high cost of equity. Conversely, more equity than debt in a company could be attributed to the high cost of debt (Marlene 113).

### Per Share Market Value of a Firm

The per-share market value of a firm is determined by the market in which a firm’s securities trade. As noted earlier, the four companies trade in different Stock Exchanges. This figure indicates how the investors value a company’s securities. The figure changes frequently because of market activity (Das 321).

### Market Value of the firm’s Equity

The market value of a firm’s equity represents how high or low market participants rate a company’s shares. It is useful in computing the weighted cost of capital. Market participants in the environments the four companies operate in may value their shares differently (Brealey 98).

### Market Value of the Firm’s Debt

The market value of the firm’s debt represents how high or low market participants rate a company’s long-term loans. It is useful in computing the weighted cost of capital because it enables analysts to compute the proportion of a company’s capital constituted of loans (Mescht 417).

## Value of SAVOLA

DCF Method.

 Initial Cash Flow: 2,000,000.00 Years: 1-5 6-10 Growth Rate: 10.00% 5.00% Terminal Growth Rate: 1.00% Discount Rate: 15.00% Shares Outstanding: 505663 Margin of Safety: 30.00% Debt Level: 13871311 Year Flows Growth Value 1 2200000 10.00% 2200000 2 2420000 10.00% 2420000 3 2662000 10.00% 2662000 4 2928200 10.00% 2928200 5 3221020 10.00% 3221020 6 3382071 5.00% 3382071 7 3551174.55 5.00% 3551174.55 8 3728733.278 5.00% 3728733.278 9 3915169.941 5.00% 3915169.941 10 4110928.438 5.00% 4110928.438 Terminal Year 4152037.723 PV of Year 1-10 Cash Flows: 32119297.21 Terminal Value: 7330858.745 Total PV of Cash Flows: 39450155.95 Number of Shares: 505663 Intrinsic Value (IV): 50.58476684 Margin of Safety IV: 35.40933679 What Percentage of IV comes from 0.18582585 the Terminal Value:

### Computational Assumptions

• The company’s initial cash flow is SAR 2000,000.
• The discount rate attributable to cash flows is 15%.
• Cash flows grow at a 10% rate for the first 5 years and 5% rate for the next 5 years.
• The investor uses a terminal growth rate of 1%.
• The company has 505663 shares outstanding and pays no dividends.

DGM Method.

 Cost of Equity = 6.69% Current Earnings per share= \$2.90 Growth Rate in Earnings per share Growth Rate Weight Historical Growth = 21.65% 40.00% Outside Estimates = 11.00% 40.00% Fundamental Growth = 17.00% 20.00% Weighted Average 16.46% Payout Ratio for high growth phase= 95.32% The dividends for the high growth phase are shown below (up to 10 years) 2 Dividends \$3.22 Growth Rate in Stable Phase = 8.00% Payout Ratio in Stable Phase = 76.80% Cost of Equity in Stable Phase = 12.23% Price at the end of growth phase = \$56.93 Present Value of dividends in high growth phase = \$9.53 Present Value of Terminal Price = \$47.18 Value of the stock = \$56.71

### Computational Assumptions

• There are two stages of growth, first and second stage.
• SAVOLA is expected to grow at a higher growth rate in the first period.
• The growth rate will drop at the end of the first period to a stable growth rate.
• The dividend payout ratio is consistent with the expected growth rate.

### Value of AGTHIA

DCF Method.

 Initial Cash Flow: 1,000,000,000.00 Years: 1-5 6-10 Growth Rate: 10.00% 5.00% Terminal Growth Rate: 1.00% Discount Rate: 15.00% Shares Outstanding: 600000000 Margin of Safety: 30.00% Debt Level: 713786000 Year Flows Growth Value 1 1100000000 10.00% 1100000000 2 1210000000 10.00% 1210000000 3 1331000000 10.00% 1331000000 4 1464100000 10.00% 1464100000 5 1610510000 10.00% 1610510000 6 1691035500 5.00% 1691035500 7 1775587275 5.00% 1775587275 8 1864366639 5.00% 1864366639 9 1957584971 5.00% 1957584971 10 2055464219 5.00% 2055464219 Terminal Year 2076018861 PV of Year 1-10 Cash Flows: 16059648604 Terminal Value: 3665429373 Total PV of Cash Flows: 19725077976 Number of Shares: 600000000 Intrinsic Value (IV): 31.68548663 Margin of Safety IV: 22.17984064 What Percentage of IV comes from 0.18582585 the Terminal Value:

### Computational Assumptions

• The company’s initial cash flow is AED 1000,000,000.
• The discount rate attributable to cash flows is 15%.
• Cash flows grow at a 10% rate for the first 5 years and 5% rate for the next 5 years.
• The investor uses a terminal growth rate of 1%.
• The company has 6000000000 shares outstanding and pays no dividends.

DGM Method.

 Cost of Equity = 1.24% Current Earnings per share= \$3.05 Growth Rate in Earnings per share Growth Rate Weight Historical Growth = 21.65% 40.00% Outside Estimates = 11.00% 40.00% Fundamental Growth = 17.00% 20.00% Weighted Average 16.46% Payout Ratio for high growth phase= 95.32% The dividends for the high growth phase are shown below (up to 10 years) 2 Dividends \$3.39 Growth Rate in Stable Phase = 8.00% Payout Ratio in Stable Phase = 76.80% Cost of Equity in Stable Phase = 12.23% Price at the end of growth phase = \$59.87 Present Value of dividends in high growth phase = \$11.85 Present Value of Terminal Price = \$57.66 Value of the stock = \$69.51

### Computational Assumptions

• There are two stages of growth, first and second stage.
• AGTHIA is expected to grow at a lower growth rate in the second period.
• The growth rate is higher in the first period but stabilizes to a stable growth rate.
• The dividend payout ratio is consistent growth rate.

### Value of NESTLE

DCF Method.

 Initial Cash Flow: 5,000,000,000.00 Years: 1-5 6-10 Growth Rate: 10.00% 5.00% Terminal Growth Rate: 1.00% Discount Rate: 15.00% Shares Outstanding: 3224800000 Margin of Safety: 30.00% Debt Level: 21743000000 Year Flows Growth Value 1 5500000000 10.00% 5500000000 2 6050000000 10.00% 6050000000 3 6655000000 10.00% 6655000000 4 7320500000 10.00% 7320500000 5 8052550000 10.00% 8052550000 6 8455177500 5.00% 8455177500 7 8877936375 5.00% 8877936375 8 9321833194 5.00% 9321833194 9 9787924853 5.00% 9787924853 10 10277321096 5.00% 10277321096 Terminal Year 10380094307 PV of Year 1-10 Cash Flows: 80298243018 Terminal Value: 18327146863 Total PV of Cash Flows: 98625389881 Number of Shares: 3224800000 Intrinsic Value (IV): 23.84097925 Margin of Safety IV: 16.68868547 What Percentage of IV comes from 0.18582585 the Terminal Value:

### Computational Assumptions

• The company’s initial cash flow is CHF 5000000000.
• The discount rate attributable to cash flows is 15%.
• Cash flows grow at a 10% rate for the first 5 years and 5% rate for the next 5 years.
• The investor uses a terminal growth rate of 1%.
• The company has 3224800000 shares outstanding and pays no dividends.

DGM Method.

 Cost of Equity = 8.48% Current Earnings per share= \$1.90 Growth Rate in Earnings per share Growth Rate Weight Historical Growth = 21.65% 40.00% Outside Estimates = 11.00% 40.00% Fundamental Growth = 17.00% 20.00% Weighted Average 16.46% Payout Ratio for high growth phase= 95.32% The dividends for the high growth phase are shown below (up to 10 years) 2 Dividends \$2.11 Growth Rate in Stable Phase = 8.00% Payout Ratio in Stable Phase = 76.80% Cost of Equity in Stable Phase = 12.23% Price at the end of growth phase = \$37.30 Present Value of dividends in high growth phase = \$3.82 Present Value of Terminal Price = \$31.95 Value of the stock = \$35.77

### Computational Assumptions

• There are two stages of growth, first and second stage.
• Nestle is expected to grow at a higher growth rate in the first period.
• The growth rate will drop at the end of the first period to a stable growth rate.
• The dividend payout ratio is consistent with the expected growth rate.

### Value of DANONE

DCF Method.

 Initial Cash Flow: 1,500,000,000.00 Years: 1-5 6-10 Growth Rate: 10.00% 5.00% Terminal Growth Rate: 1.00% Discount Rate: 15.00% Shares Outstanding: 631030000 Margin of Safety: 30.00% Debt Level: 8671000000 Year Flows Growth Value 1 1650000000 10.00% 1650000000 2 1815000000 10.00% 1815000000 3 1996500000 10.00% 1996500000 4 2196150000 10.00% 2196150000 5 2415765000 10.00% 2415765000 6 2536553250 5.00% 2536553250 7 2663380913 5.00% 2663380913 8 2796549958 5.00% 2796549958 9 2936377456 5.00% 2936377456 10 3083196329 5.00% 3083196329 Terminal Year 3114028292 PV of Year 1-10 Cash Flows: 24089472905 Terminal Value: 5498144059 Total PV of Cash Flows: 29587616964 Number of Shares: 631030000 Intrinsic Value (IV): 33.14678694 Margin of Safety IV: 23.20275086 What Percentage of IV comes from 0.18582585 the Terminal Value:

### Computational Assumptions

• The company’s initial cash flow is EUR 1500000000.
• The discount rate attributable to cash flows is 15%.
• Cash flows grow at a 10% rate for the first 5 years and 5% rate for the next 5 years.
• The investor uses a terminal growth rate of 1%.
• The company has 631030000 shares outstanding and pays no dividends.

DGM Method.

 Cost of Equity = -0.12% Current Earnings per share= \$1.67 Growth Rate in Earnings per share Growth Rate Weight Historical Growth = 21.65% 40.00% Outside Estimates = 11.00% 40.00% Fundamental Growth = 17.00% 20.00% Weighted Average 16.46% Payout Ratio for high growth phase= 95.32% The dividends for the high growth phase are shown below (up to 10 years) 2 Dividends \$1.85 Growth Rate in Stable Phase = 8.00% Payout Ratio in Stable Phase = 76.80% Cost of Equity in Stable Phase = 12.23% Price at the end of growth phase = \$32.78 Present Value of dividends in high growth phase = Present Value of Terminal Price = Value of the stock =

### Computational Assumptions

• There are two stages of growth, first and second stage.
• DANONE is expected to grow at a lower growth rate in the second period.
• The growth rate is higher in the first period but stabilizes to a stable growth rate.
• The dividend payout ratio is consistent growth rate.

## Relationship with Modigliani–Miller theorem

The Modigliani–Miller theorem alludes that in the absence of all the factors that affect WACC, the manner of financing the operations of a firm does not affect the value of a firm. The findings do not support the theory. All the firms in the cases above are financed through either equity or debt and the absence of the other factors does not change that fact. If the fact is unchanged, so does the value.

## Relating firm value with leverage

The value of a firm does not give it advantage. Stock markets are heavily opinionated. A firm operates in an environment where ratings, relationships with governments, tax rates among others are the determinants of leverage. Hence, a firm should work towards enhancing these factors.

## Works Cited

Bodie, Kane. Investments, New York: McGraw-Hill Irwin, 2008. Print.

Brealey, Richard. Principles of Corporate Finance, Boston: McGraw-Hill/Irwin, 2008. Print.

Das, Markowitz. Portfolio optimization with mental accounts. Journal of Financial and Quantitative Analysis 45.1 (2010): 311-334. Print.

Fama, Eline & French, Kolster. The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives 18.3 (2004): 25-46. Print.

Levich, Minor. International Financial Market, New York: McGraw-Hill, 2001. Print.

Marlene, Aston. Auditing fundamentals, New York: McGraw-Hill, 2011. Print.

Mescht, Davidson. How entrepreneurs deal with ethical challenges – applying the synergy star technique. Journal of Business Ethics 71.1 (2007): 411- 423. Print.

Perold, Ashton. The Capital Asset Pricing Model. Journal of Economic Perspectives 18.4 (2004): 3-24. Print.

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BusinessEssay. (2022) 'The Weighted Average Cost of Capital'. 16 December.

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1. BusinessEssay. "The Weighted Average Cost of Capital." December 16, 2022. https://business-essay.com/the-weighted-average-cost-of-capital/.

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