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The concept of cost of capital is pivotal in capital budgeting and crucial for corporations like Walmart to make informed investment decisions. It represents the funding cost a company incurs for projects or assets, which can be financed through various sources such as debt and equity. The cost of capital serves as the benchmark rate for evaluating the profitability of investment projects.
Cost of capital is necessary for capital budgeting. It is a cost of funding that the company provide for investing in projects or assets which can be funded from one or many sources such as funding from indebtedness that cost will be interest burden as we known as cost of debt and funding form issuing preferred shares or equity shares that cost will be dividend payouts as we known as cost of equity.
Therefore each of companies have different proportions of funding depending on the risk that they can bear and the required rate of return that they want.
We can also call the cost of capital otherwise as the required return that investors or shares of equity expected and we can estimate it from the weighted average cost of capital (WACC) that is one of tools to help manager making investment decisions in each project to worth the risk compared to the return.
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Moreover, we can use the WACC to discount the future cash flow to be the intrinsic value of projects or company.
From we have mentioned above, cost of capital is minimum rate that the company require in each projects and also help Walmart to make decision to accept or not in each projects by using NPV approach or IRR approach so Dale and Lee want to know what hurdle rate that Walmart should use for its annual investment in capital projects because they aren’t sure about the hurdle rate which should be the same as the hurdle rate that the company investing in more store in US, remodelling , or investing internationally or not.
And also Walmart’s cost of capital can help to make investment decisions in the future projects that the projects’ return should more than the company’s hurdle rate in the present.
We have many methods to estimate the cost of debt which is the return that company provides to creditors(debt holders) to compensate for risk from lending to the company.
In this analysis, the cost of long-term debt is estimated by yield to maturity approach. The reason why we do not use current interest rate plus firm’s credit spread approach and synthetic rating approach are that we cannot observe Walmart’s recent borrowing history to approximate credit spread from this case study and Walmart already has existing bonds in the market. We use the yield to maturity instead of a coupon rate of Walmart’s bonds which issued on February 15,2000 because the coupon rate does not reflect the bond’s market value at the current time. We use yield to maturity of Walmart bond mature on February 15,2030 which has 11 years left until maturity which equals 3.53% as the cost of long term debt because the yield to maturity (YTM) is the annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. In other words, it is the yield that equates the present value of the bond’s promised payments to its market price.
Preferred shares is one of the company's sources of funding that company can raise the money for investing in projects which have already been planned. According to pecking order theory, cost of this kind of funding is the dividend that company pays to preferred shareholders that must be higher than the cost of debt because creditors (debt holders) are the first priority that are entitled to a higher claim to asset before preferred shareholders and the company have to pay interest every period depending on the agreement and cost of preferred shares are also lower than cost of shareholder equity because the company have to pay cost of funding in term of dividend to preferred shareholders before equity shareholders even though company can suspend to pay preferred dividends but company must promist to make that up later that different from dividend which company pay to equity shareholders that can skip depend on company’s agreement and strategy.
If Walmart had issued preferred shares, Dale and Lee should include the cost of preferred shares into the cost of capital. The cost of capital may increase or decrease in the immediate term depending on the proportion of debt and equity that the company uses to fund at the present. If the proportion of debt is higher than equity, using more preferred stock may cause WACC to go up but If the proportion of debt is lower than equity, using more preferred stock may cause WACC to go down.
In the longer term, cost of capital may be uncertain because many factors do not remain constant following the change in capital structure. By using more preferred stock, debt-to-equity ratio will decrease which results in WACC may go down by using less financial leverage that can reduce overall risk. On the other hand, WACC might go up because common equity will require a higher rate of return due to the company bearing higher financial risk because of preferred dividend obligation.
A deferred tax is caused by temporary accounting differences between the income statement filed for GAAP purpose (straight line depreciation) and the income statement for tax purpose (MACRS depreciation). In the tax rules, we allow accelerated depreciation calculation, but it is not allow for accounting rule. So, the temporary difference between the two methods of depreciation calculation leads to the different timing of tax expense. The straight-line depreciation method produces a lower depreciation than an accelerated depreciation method, which makes an accounting income before tax is higher than a taxable income.
To align the principle of accounting, we will account for deferred tax as a solution. If the tax expense which derives from accounting rule is higher than tax rule, which implies that we overpay the tax expense in the current period. We will adjust the excess tax expense as Deferred Tax Asset on the left side of the balance sheet, we can receive cashback in the future as we overpaid the tax expense, or we can reduce tax expense in the future by paying in the amount of the tax expense excluding the deferred tax asset.
On the other hand, if the tax expense in the tax rule is higher than accounting rule, which refers to we underpay tax in the current period. We will add the shortage as Deferred Tax Liability on the right side of the balance sheet, we need to pay the deferred tax liability in the future, which will increase the tax obligation in the next period.
We calculate a deferred tax liability as to the following formula:
Deferred tax liability = (Accelerated depreciation – straight line depreciation) * Tax%
In Walmart's WACC calculation, we do not include deferred tax as a part of long-term debt because the deferred tax is not the source of funds to operate the new project, and we cannot observe the payment timing of tax obligation. It is a regulator difference, which not a factor that we suppose to consider in investment decisions.
The most common used to estimate the cost of equity is the Capital Asset Pricing Model (CAPM) that determines the expected return for assets by taking into account the systematic risk.
The formula for calculating the expected return of an asset given its risk is as follows:
Re = Risk free rate + Beta (Market Risk Premium)
Which Market Risk premium = Expected Market return – risk free rate
Risk free rate is the rate of return or the interest rate an investor would expect to earn from investing in zero risk securities over an investment period. Risk free rate can be represented by the current yield to maturity of a government bond. From our analysis, we use the latest 30-year treasury yield as risk free rate because it is 30 years forward looking which reflect business cycle and based on the assumption that investors invest in equity in the long run. The 30-year treasury yield on 19 February 2019 is 2.99%(Exhibit1) so the risk free rate used in the CAPM model is 2.99%.
Market Risk premium is the difference between the expected market return and the risk-free rate that describes the additional return an investor would expect to compensate for investing in market portfolio instead of zero risk portfolio. To estimate expected market return, we use the geometric average return in U.S. capital markets over the period 1969-2018 (Exhibit 5) which equals 9.73% because a geometric mean takes into account the compounding effect and 49 years period (1969-2018) is appropriate since it might be long enough to cover the business cycle and cover period since Walmart was opened first store in 1962 in Rogers, Arkansa. From market return and risk free rate that we selected, the market risk premium which is difference between geometric average return in U.S. capital markets and The 30-year treasury yield equals 6.74%
The beta coefficient is a risk measure that describes a stock’s systematic risk compared to market risk which its beta equal to one. If a stock is more volatile than the market, its beta will be greater than one. On the other hand, if a stock’s beta is less than one, a stock is less volatile than the market. As we believe company performance will move relatively with the market in the long term, we use adjusted beta which equals 0.71 from adjusted beta formula:
Adjusted beta = 0.67* Raw beta + 0.33* market’s beta
= ( 0.67 * 0.56 ) + 0.33
= 0.71
Then plug in all variables that we mention above in CAPM model:
Re = Risk free rate + *( Market Risk Premium )
Re = 2.99% + 0.71 * ( 9.73% - 2.99% )
Re = 7.78%
Walmart’s cost of equity is 7.78%
The weighted average cost of capital (WACC) is a calculation of a firm's marginal cost of capital in which each category of capital is proportionately weighted. All sources of capital that company can use to support its investment program including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
The formula for calculating WACC is as follows:
WACC=D+EE×Re+D+ED×Rd×(1−Tax rate)
E = market value of the firm's equity
D = market value of the firm's debt
D + E = firm’s total capital (equity and debt)
The cost of equity is the rate of return required by a company’s common shareholders. From the CAPM model which we estimated, the cost of equity is 7.78%.
The cost of debt is the cost of debt financing to a company when it issues a bond or takes out a bank loan. We include only the long term cost of debt financing in this calculation because of the matching between maturity of the source of fund and the project duration which mainly need long-term source of fund. To estimate the before-tax cost of debt, we use the bond’s yield to maturity as the cost of debt which equals 3.53%. The marginal cost of debt financing is the cost of debt after considering the allowable deduction for interest on debt based on the country’s tax law. We use 21% as a corporate tax rate because the interest tax shield should be calculated at the new tax rate from new U.S. tax regulation.
The amount of debt financing is the sum of long-term debt and capital leases and the current portion of long-term debt and capital leases in terms of book value which equals $52,808 millions(Exhibit 2). We use book value of long-term debt instead of market value of long-term debt because we cannot observe market value of long-term debt and this is the next best alternative to determine long-term debt value.
The market value of equity is calculated by multiplying the Walmart’s number of outstanding shares which is approximately 2,945 million shares outstanding and Walmart's current stock price which is $96.08 (Exhibit 4). After we calculate, the market value of equity equals $282,956 millions
From the amount of debt and equity calculated above, the total capital is 335,764 millions.
Hurdle rate is the minimum rate that a company expects to earn when investing in a project. Hence the hurdle rate is also referred to as the company's required rate of return. In order to accept a project, its internal rate of return must equal or exceed the hurdle rate. The hurdle rate is usually larger than the cost of capital when the company has many investment opportunities and for projects that have a higher level of risk.
WACC is a minimum hurdle rate because it is a blend of the cost of debt and the cost of equity that the company uses to fund a project. WACC will help to discount the future value of cash flows back to the present value of each project or asset and help us to make the right decision that maximizes shareholder equity. We don’t want to accept the project whose internal rate of return is lower than the company’s WACC. By the way, WACC may be different among several projects. The WACC of a project may be higher or lower than the firm's WACC depending on the project's characteristics. The high risk project requires high return so the WACC of the high risk project is higher than the low risk project. The hurdle is high when the project’s risk is high. If we use overall WACC to evaluate the project, we will tend to give positive bias (accept) toward the risky project because it gives us a higher return and negative bias (reject) toward the low-risk project.
Understanding and accurately calculating the cost of capital is essential for strategic investment decision-making. For Walmart, careful estimation of the cost of equity and debt, considering deferred taxes, and appropriately adjusting the hurdle rate for project-specific risks are crucial steps in ensuring that investments align with shareholder value maximization.
Analyzing the Cost of Capital: A Comprehensive Guide for Walmart. (2024, Feb 21). Retrieved from https://studymoose.com/document/analyzing-the-cost-of-capital-a-comprehensive-guide-for-walmart
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