WACC Calculation: Arrow Electronics Limited
Calculation of WACC
WACC: Weight of short-term debt* Cost of ST debt(1-tax rate)+ Weight of long-term debt* Cost of LT debt(1-tax rate)+ Weight of equity* Cost of equity
= 0.0019* 0.0274+ 0.2987* 0.0378+ 0.6994* 0.0707
= 6.085%
Calculative Notes:
i) Cost of debt:
-Cost of Long-term debt
The cost of long-term bonds issued by the company has been calculated on the weighted average basis:
-Cost of Short term debt
The information relating to the short-term debt of the company was available in Note-6 of the financial statement where we found that during the year the amount of short-term debt owed by the company amounts to $13.454 million. The company has also disclosed that short-term borrowings were used exclusively for meeting working capital requirements while the weighted average interest rate of short term borrowings for 2014 was 3.8%.
iii) Cost of Equity:
For the purpose of calculation of cost of equity of the company, we have relied on CAPM model:
Cost of equity: RFR+Beta (Equity Risk Premium)
= 0.21+ 1.14(6)
= 7.05%
RFR= 10-year US Treasury yield= 0.21%
Beta= Volatility of the stock returns to the market index= 1.14
Equity Risk Premium: Excess of stock return over risk-free rate= 6%
iv) Effective Tax Rate: 27.69%
Importance of WACC in decision making
Weighted Average Cost of Capital (WACC) represents the cost of financing firm’s assets. In other words, it is the opportunity cost of the capital invested to finance the firm’s asset base. Calculated by summation of the weighted cost of all the sources of the capital borrowed by the firm, this financial metric has an immense importance at the time of decision making. Below we have discussed the possible utility of WACC multiple at the time of decision making by Arrow Electronics Limited:
i) Evaluating the projects:
WACC represents the benchmark rate that a company must earn for the investors. Accordingly, all the projects being considered by an entity are based on the WACC multiple. In other words, only if project yields a return higher than the WACC rate, it is considered for investment or is otherwise abandoned.
ii) Using NPV Analysis
As indicated earlier, WACC represents the benchmark or the hurdle rate required to be earned by an entity from their projects. Henceforth, this feature of WACC make it suitable for being used as a discount factor at the time of NPV calculation for a project. Important to note, WACC represents the average risk owed by the company’s projects. Therefore, if any project is having more or less risk embedded with it, WACC rate should be adjusted accordingly. For instance, countries like the US and UK do not carry any country risk, however, if Arrow Electronics is setting up its plant in nations such as Pakistan or Venezuela, the WACC rate should include appropriate country risk premium.
iii) Tool of value estimation
Apart from evaluating the prospective list of projects, WACC is also used to value a company which an entity is willing to acquire. Just like any other project, the acquirer company will estimate the future cash flows of the target company and will then discount them using appropriate WACC rate(of the target company) and then divided the enterprise value with the outstanding shares of the target company to get per share value. Henceforth, by comparing the intrinsic value with that of current market value, the acquirer can estimate whether the target company is presently overvalued or undervalued and then frame the decision making policies accordingly.
In addition to the estimation of the intrinsic share value of the target company, the acquirer company may also use WACC rate to estimate the economic value added(EVA) multiple of the target company by deducting WACC rate from the net profit of the target company. Henceforth, WACC also acts as a tool for value creation.
Importance of Optimal Capital Structure
According to MM Proposition with taxes, since debt financing provides the tax shield advantage, an entity is likely to minimize the WACC rate at 100% debt thus maximizing the value of the firm. However, this theory does not hold in the reality as an additional debt borrowing is always accompanied by financial distress and higher risk. This concept was duly postulated in the static trade-off theory which recognized that even though a debt-issuing firm may benefit from the tax shield associated with interest expense on debt borrowings, however, at some point, the costs of financial distress will exceed the tax benefits of debt. Henceforth, rather than 100% debt capital structure, a finance manager should always seek to balance the benefits of debt with the costs of financial distress and identify an optimal capital structure.
Important to note, optimal capital structure represents that proportion of debt and equity where the value of the firm is maximized and cost of capital is minimized. The concept of optimal capital structure is explained in the diagram below:
As noted from the above figure, the after-tax cost of debt has an upward slope due to increasing cost of financial distress that comes along with additional debt borrowing. Therefore, as the firm bears additional financial risk, cost of equity also increases as some of the costs of financial distress is also borne by the equity shareholders. Henceforth, the firm will achieve the optimal proportion of debt when the marginal benefit provided by additional debt borrowing in the form of tax shield is equal to the marginal costs of financial distress incurred from additional debt. This is the point of optimal capital structure as it this point of debt borrowing, WACC is minimized and firm value is maximized.
References
Arrow Electronics. "Annual Report 2014." Annual Report . 2014.
Bonds: Arrow Electronics. n.d. 1 February 2016 <http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=ARW&Country=USA>.
CNBC. US 10 year treasury yield. n.d. 3 December 2015 <http://data.cnbc.com/quotes/US10Y>.
Damodaran, Aswath. Equity Risk Premium. n.d. 27 October 2015 <http://pages.stern.nyu.edu/~adamodar/>.
Importance and Use of Weighted Average Cost of Capital (WACC). n.d. 12 February 2016 <http://www.efinancemanagement.com/investment-decisions/importance-and-use-of-weighted-average-cost-of-capital-wacc>.
Key Statistics: Arrow Electronics. n.d. 12 February 2016 <https://in.finance.yahoo.com/q/ks?s=ARW>.
The MM Capital Structure vs. The Tradeoff Theory of Leverage. n.d. 17 September 2015 <http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/mm-capital-structure-versus-tradeoff-leverage.asp>.
