Wacc Computation
Case Study II : Weighted Average Cost of Capital
Introduction and objectives
This paper aims at describing a way to compute the Weighted Average Cost of Capital (WACC). This method is often used by company management to determine the economic feasibility of different projects and thus to compute the NPV of a specific project by discounting cash-flows. The WACC determines the return that the company should generate to satisfy its debt-holders. For the company, it consists in a tool for projects decision-making, whereas for the creditors, it is in an indicator of what they can expect to receive as return from their investments and a measure of the global risk associated to the company. Our choice fell on Hewlett-Packard (HPQ), whose activities are computer hardwares and is part of the S&P500.
Assumptions
Cost of equity:
Cost of equity is computed by using the CAPM formula (1). This equation links the risk premium on the market (S&P500) to the excess return of the stock (HPQ) by a factor Beta (B). B is the covariance between the market and stock return divided by the variance of the market.
ErE=rf+β∙E[risk premium] (1)
1. Risk-free rate : The first thing to be found is the risk-free rate. The WACC evaluation should be made through eyes of the company’s most probable investors, which we assumed to be American as HPQ is listed on the US market. The best proxy for rf is therefore the US T-bills rate. The time basis used to reflect the lifetime of the project is assumed to be 10 years, as we estimated it was an acceptable horizon, typically used in case studies (this estimation was reasonably confirmed by bond issuances by HPQ we observed). Hence, the best evaluation taken is 3.36% on 01.03.2011 for a maturity of 10 years (www.treasury.gov).
2. Market return : The second element to find is the market rate. We based our choice on the S&P 500 return since HPQ is quoted in the U.S. market. Through this rate, we can
Introduction and objectives
This paper aims at describing a way to compute the Weighted Average Cost of Capital (WACC). This method is often used by company management to determine the economic feasibility of different projects and thus to compute the NPV of a specific project by discounting cash-flows. The WACC determines the return that the company should generate to satisfy its debt-holders. For the company, it consists in a tool for projects decision-making, whereas for the creditors, it is in an indicator of what they can expect to receive as return from their investments and a measure of the global risk associated to the company. Our choice fell on Hewlett-Packard (HPQ), whose activities are computer hardwares and is part of the S&P500.
Assumptions
Cost of equity:
Cost of equity is computed by using the CAPM formula (1). This equation links the risk premium on the market (S&P500) to the excess return of the stock (HPQ) by a factor Beta (B). B is the covariance between the market and stock return divided by the variance of the market.
ErE=rf+β∙E[risk premium] (1)
1. Risk-free rate : The first thing to be found is the risk-free rate. The WACC evaluation should be made through eyes of the company’s most probable investors, which we assumed to be American as HPQ is listed on the US market. The best proxy for rf is therefore the US T-bills rate. The time basis used to reflect the lifetime of the project is assumed to be 10 years, as we estimated it was an acceptable horizon, typically used in case studies (this estimation was reasonably confirmed by bond issuances by HPQ we observed). Hence, the best evaluation taken is 3.36% on 01.03.2011 for a maturity of 10 years (www.treasury.gov).
2. Market return : The second element to find is the market rate. We based our choice on the S&P 500 return since HPQ is quoted in the U.S. market. Through this rate, we can