Tag Archives: Beta

10Oct/11

What is the Weighted Average Cost of Capital?

We are a few weeks into the series of finance-related posts.  I figured I would explain this series a little before we go into today’s topic.  I am currently working on an Masters of Business Administration at Cardinal Stritch University, in Glendale, WI.  As I go through my homework, I often find that the textbook is not the best in the world and I have to pull concepts from a number of source.  With this content, I try to develop a reasonable narrative that pulls things together.  When I blog a topic like today’s topic, it’s my highly public way of doing that.  I hope it helps someone else out there.

Today, we’re going to talk a little about the Weighted Average Cost of Capital (WACC).  According to the third edition of Corporate Finance: Core Principles & Applications, “the WACC is the minimum return a company needs to satisfy all of its investors, including stockholders, bondholders, and preferred stockholders.”  According to investopedia, “all else being equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.”

So, essentially the WACC is the amount of profit that the firm has to earn, in order to satisfy all of its obligations and if the firm starts to look like a worse investment, they will need to earn more profit.  The formula for the WACC (according to investopedia) is:

WACC = (E/V)*R_e+(D/V)*R_d*(1-T_c)

Where:
R_E = cost of equity
R_d = cost of debt
E = the market value of the firm’s equity
D = the market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percent of financing that is debt
T_c = the corporate tax rate

So, let’s look at a small example problem.  Let’s say that a firm has a cost of debt of 5.2% and a cost of equity of 9.1%.  Let’s also say that the corporate tax rate is 39% and the firm’s debt-equity ratio is 0.6.  How would you figure out the firm’s WACC?

5.2% implies 5.2 parts debt for 10 parts equity and because the value is equal to the sum of debt plus the equity, the debt-value ratio is 5.2/(5.2+10)=0.342105.  The equity-value ratio would then be 10/(5.2+10)=0.657895.

.657895 * 9.1% + .342105 * 5.2% * (1 - 39%) = 0.07072 = 7.072%

So, now that we know what the WACC is and how it’s calculated, is there an easy way to find the WACC for a publicly traded company?  Well, for better or worse, there is apparently an app for that. 🙂

19Sep/11

What is the capital asset pricing model?


Last week, we talked about what a company’s beta is.  I figured that this week, we would learn about the Capital Asset Pricing Model (CAPM).  According to Investopedia, the CAPM is “a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.”

According to the third edition of Corporate Finance: Core Principles & Applications, the CAPM “implies that the expected return on a security is linearly to its beta.”

The equation: E(R) = R_f + beta * (E(R_m) - R_f)
Where:
E(R) is the Expect Return on a Security
R_f is the Risk-free rate
beta is the Beta of the security
E(R_m) is the Expected return on market

 

 

In the above graph, the Security Market Line is the depiction of the actual CAPM.  Lets try an example.  If the risk-free rate is 1%, the beta of the security is 1.2, and the expected market return on the market is 11%, then stock should return 13%.

12Sep/11

What is a company’s beta?

This is a topic that I recently dealt with within an assignment for class.  Investopedia defines a company’s beta as “a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.”

Illustration of Beta

According to the third edition of Corporate Finance: Core Principles & Applications, when you graph the return on the particular security on theY axis and the return on the market on the X axis, the slope of the line is the Beta.

A beta of 1.21 would mean that for every 1% that the market moves, the company would move 1.21%.  A high beta  would mean that the company is risky.  If the return on the market goes down at all, the return on the security goes down much faster.

Chances are, you will not find a stock with a negative beta but it would mean that the return goes up when the return on the market goes down.

If the beta is zero, it means that the market has no influence at all on the security.

If a security has a beta of one, it means that the return moves with the fund.  An example could be an index fund.

If the security has a beta greater than one, the security is more volatile than the market.

How do you find a company’s beta?  One way is to go to finance.yahoo.com and look under key statistics.  If you prefer to you Google Finance, the same number is listed at the top of the page, next to the stock quote.