U.S. Department of the Treasury shows us that the value of risk-free rate was 3.05% on May 30, 2014 (U.S. Department of the Treasury, 2014). US Treasury bills’ yields were chosen as the source of risk-free rate, because virtually these financial instruments do not have any risks (except for sovereign). They are backed up by the Government of the USA. Therefore, even if default occurs, there is always a possibility to print out more money. As for the maturity of US T-bills it should coincide with the maturity of financial instrument that is considered (in this case IBM stocks), which is long-term maturity of 10 to 20 years.
Market risk premium equals to 2.45% (expected return on market – risk-free rate = 5.5%-3.05%), whereas beta of the IBM stocks is 0.66 (Yahoo! Finance, 2014).
Just recently the IBM has declared quarterly cash dividend of $1.10 per common stock payable June 10, 2014 (Shelton/IBM, D., 2014). This dividend payment represents 16% growth in comparison to the last dividend payment. The number of shares outstanding on March 31, 2014 was 1.05 bln (Fay, M., Bukovinsky, J., 2014). Thus, the upcoming dividend payment will constitute $1.155 bln ($1.1*1.05bln shares). It indicates that the IBM is in maturity state of business, as it uses cash for dividends rather than reinvestments.
Cost of Equity is calculated as CAPM (risk-free rate + beta*market risk premium). It equals to 4.667% (3.05% + 0.66*2.45%). Cost of Preferred Equity equals to annual dividends on preferred stock divided by current market price of preferred stock + growth in dividends, however, at December 31, 2013 none of authorized preferred stock were issued (Fay, M., Bukovinsky, J., 2014). Therefore, there is no cost of preferred stock.
In calculation of WACC after-tax cost of debt is utilized. IBM pays tax rate of 20% (Fay, M., Bukovinsky, J., 2014). As for YTM Morning Star financial database provides public with this data for IBM stocks. In this case as the maturity is from 10 to 20 years, IBM bonds maturing in 2024 are of interest. There is a bond paying 3.625 coupons at price of $102.4 with 3.33% YTM (Morning Star, 2014). It suits the investment choice very well. Therefore, after tax cost of debt equals to 2.664% (3.33%*(1-0.2)).
As of 2014 first quarter report of IBM capital structure of the company is following: common stock of $51,943 and long-term debt of $34.668 (Fay, M., Bukovinsky, J., 2014). Thus, the percentage distribution of capital structure is 59.97% debt and 40.03. WACC equals to 3.46%.
WACC = 0.5997*2.664%+0.4003*4.667%=0.015976+0.018682=3.46%
WACC gives us reasonable estimate discount rate that companies can apply in order to calculate net present value of projects that generate cash flows that resemble cash flows of the whole company. It can also be regarded as the minimum rate of return that the IBM has to earn in order to be able to repay its debt and satisfy stockholders. In order to check whether WACC is appropriate or not, we can
The issue with WACC is the fact that it is based on estimates. Debt instruments of any company have its own maturity dates; therefore there is always a risk that we will not be able to find Treasury bill with the same term. In this case T-bills with the nearest maturities are used. Another drawback is the fact that WACC does not account for floating costs.
References
Fay, M., & Bukovinsky, J. (2014). IBM News room - 2014-04-16 IBM Reports 2014 First-Quarter Results - United States. Retrieved June 1, 2014, from https://www-03.ibm.com/press/us/en/pressrelease/43696.wss
Morning Star. (2014, June 1). International Business Machines Corporation (IBM). Retrieved June 1, 2014, from http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=ibm
Shelton/IBM, D. (2014). IBM News room - 2014-04-29 IBM Board Approves 16 Percent
Increase in Quarterly Cash Dividend - United States. Retrieved June 1, 2014, from
https://www-03.ibm.com/press/us/en/pressrelease/43810.wss
U.S. Department of the Treasury. (2014, June 1). Daily Treasury Long Term Rate
Data. Retrieved June 1, 2014, from http://www.treasury.gov/resource-center/data-chart-
center/interest-rates/Pages/TextView.aspx?data=longtermrate
Yahoo! Finance. (2014, June 1). International Business Machines Corporation (IBM).
Retrieved June 1, 2014, from https://finance.yahoo.com/q;_ylt=ApPJAe5
