FINANCIAL MANAGEMENT

 

 

WACC CALCULATION

Capital Structure is Long-term Financing Structure of the Company = Distribution of the long term financing sources for the company = components and their weights of the long term financing sources. Capital structure has fundamentally three components; (1) long term debt, (2) preferred stock, and (3) common equity. If there is a permanent short-term debt, like revolving credit line, it should be added to the long-term debt!

If the Optimal Capital structure for the company is defined, then use the optimal weights of the capital structure components of the company. If it is not defined but assumed explicitly or implicitly that the current capital structure is optimal, then compute the weights from the Balance Sheet of the company. If you are calculating from the Balance Sheet, first thing you have to do is to obtain the value of the capital structure, and then divide the value of each component by the value of the capital structure. Value of the capital structure is also called sometimes, inaccurately, as the value of the company. The value of the capital structure is the Weight Base (W) for WACC calculations Value of the capital structure can be expressed by the following equation

W = Long term Debt (LD) + Preferred Stock (PS) + Common Equity (CE)

Common equity can be best explained by the following equation:

Common Equity = Common Stock + Paid-in Capital + Retained Earnings

wd = LD/W = weight of Long term Debt within the capital structure

wp = PS/W = weight of Preferred Stock within the capital structure

wc = CE/W = weight of Common Equity within the capital structure

If the new investment will be finance by both retained earnings and new equity, then apply the following procedure.

Calculate percentage of common equity that will be financed by (a) Retain Earnings and (b) by New Equity. Call the first percentage wr and the second we. Multiply wc by wr and call it wcr and use it as the weight for retained earnings and Multiply wc by we and call it wce. Use them as respective weights for Retained earnings and new common stock.

t = Corporate tax rate

kd = Cost of New Debt = Interest Rate on New Debt = Interest Rate paid to New Credit Holders

kp = Cost of New Preferred Stock = Required Rate of Return on Preferred Stock = Interest Rate paid to Preferred Stock Holders.

Dp = Annual Dividend to the new Preferred Stock

Pp = Price of the new issue Preferred Stock

Fp = Floatation cost for issuing new Preferred Stock expressed in percentage of the new Preferred Stock Price.

ks = Cost of New Retained Earrings = Cost of Common Equity = Required Rate of Return to Common Stock Holders

This is for the retained earnings that have not been dedicated to any thing yet. Most of the time it is the latest retained earnings. All historical retained earnings are dedicated to some assets in the Asset site of the Balance Sheet already. We can calculate Ks by using different methods like (1) Constant Growth, (2) Non-constant Growth, (3) CAPM, etc.

Constant Growth Model:

D1 = Dividends (next period) for Common Stock Holders

D1 = D0 (1+g)

P0 = Market Price (current) of the Common Stock

g = Expected Growth Rate. Calculation of g is given below.

CAPM Method:

Ks = krf + b(km-krf)

b = Beta of the company

krf = Risk Free Rate

km = Market Required Rate of Return

ke = Cost of New Equity = (Required rate of Return to Common Stock Holders + Flotation Cost)

We can calculate Ks by using different methods like (1) Constant Growth, or(2) CAPM, etc.

Constant Growth Model:

Fe = Floatation cost for issuing new Common Stock expressed in percentage of the new Common Stock Price.

CAPM Model

ke = krf + b(km-krf) + Flotation Cost Adjustment Factor

The Flotation Cost Adjustment Factor expressed in percentage points.

Flotation Cost Adjustment Factor =

 

GROWTH OF ROE CALCULATION

Growth rate g can be calculated by utilizing (a) Historical Growth Model or (b) Retention Growth Model.

  1. Historical Growth Model:

Historical Growth can be calculated by using (1) Least Square Regression or (2) Average-to-Average Model. EPS data is best suited for this purpose.

However, DPS or average of EPS+DPS can also be used.

  1. Least Squire Regression Method: Practical calculation (on Excel); =logest(EPS_Range, Years_Range)-1.
  2. Theoretical structure; exponential value of the slope of log values of EPS in a linear regression minus one.

  3. Average to Average Method: last 8 years, compute the arithmetic average of furthest 3 years compute the arithmetic average of the last 3 years (skip the middle two years) compute the geometric average from the two average points.

=(Average(EPS1+EPS2+EPS3)/Average(EPS6+EPS7+EPS8))^(1/5)-1

n = 5 because the first average is at period 2 second average is at 7 so 7-2 = 5.

Example for growth rate calculations:

Years EPS Averages

1981

2.08

1982

2.23

1983

2.38

1984

2.26

1985

2.21

1986

2.4

1987

2

1988

3.02

1989

3.56

3.33

1990

3.4

1991

4.65

1992

5.12

1993

5.14

1994

4.05

4.97

1995

5.73

Least Square Method: Growth Rate = 7.09%

Average-to-Average : Growth Rate = 8.37%

  1. Retention Growth Model:

g = (1-y)ROE

y = Dividend Pay-Out-Ratio

If the dividend pay-out-ratio changes over the time, then the arithmetic average of historical rates or targeted rate can be used. To calculate the Dividend Pay-Out-Ratio, divide Dividends by Profits After Interest and Taxes (Net Income).

ROE can be calculated from historical data by dividing Profits After Interest and Taxes by Common Equity (= Share Capital + Reserves)

Since different methods will most likely yield different results. The best way to calculate growth rate is to calculate it using two or more methods, considering trends and other information and deciding a reasonable rate within the calculated range. For example, if the historical method yield 6.5% and the retention method yield 7.5% you can choose a growth rate at the higher end 7.5%, assuming the trend of the growth justifies it. You can choose 6.5% if you want to be more conservative, or you can choose let say 7%, which is in between.