Wal Mart CAPM and WACC

Wal-Mart cost of capital

Slide 1: The WACC is the weighted-average cost of capital. The capital structure of a firm consists of two main components – debt and equity. Wal-Mart does not have preferred shares, so they can be excluded from this calculation. The cost of equity and cost of debt are different, so the weighted average cost of capital is the weighted average of the cost of equity and the cost of debt, as illustrated in the following formula:

Slide 2: Equity versus Debt

The choice between equity and debt reflects the trade-off between a number of different factors, including risk, control and access to capital. The risk characteristics of equity and debt are different, which is the main reason that they have different costs to the company. Equity payouts are subordinated to debt payouts, because debt payouts are done on a pre-tax basis and equity pay-outs are done on an after-tax basis. Thus, debtholders have lower risk, and demand a lower return. Equity shareholders, having higher risk, demand a higher return. For almost any company, the cost of debt will thus be lower than the cost of equity.

Slide 3: Cost of Debt

There are several components to the cost of debt. One cannot look at the face value interest rate, because that does not reflect today's market conditions. If the company has recently issued debt, that would be the easiest way to estimate the cost of debt. If there has not been a recent debt issue, then further research will need to be conducted.

Thus, the cost of debt can be found looking at the prevailing yield on the company's bonds, if they have any. This is the rate that the company would have to pay if it issued that debt today. The cost of debt will typically be estimated, because either the company does not have any bonds, or it has many, at different time periods. The best practice for determining which yield makes the most sense to build into the cost of debt should reflect the time period remaining on the company's current outstanding bonds.

Slide 4: Wal-Mart Cost of Debt

Just a couple of months ago, Wal-Mart issued debt privately. The debt was 30-year term, at 75 basis points above Treasuries (Smith & Boyle, 2017). There is no reason to think that the spread would have changed, as Wal-Mart's underlying financial condition has not changed in that time. The company's bond rating was affirmed in 2015 and has not changed since (Moody's, 2015). The current rate on 30-year Treasuries is 2.88%. This puts the Wal-Mart cost of debt at 3.63%.

Slide 5: Cost of Equity

The cost of equity has a number of different components. The first is the risk-free return rate, the second is the market risk premium and the third is company-specific risk. This is the capital asset pricing model:

Slide 7: Risk-Free Rate

There are three components to the cost of equity. The risk-free rate is the Treasury rate, because short-term Treasuries are de facto risk-free. The Treasury can print more money if it has to, so these will always be paid, technically. That there is no risk of default makes these risk-free securities. The risk free rate is presently 1.31%

Slide 8: Market Risk Premium

A study of over 1500 analysts, professors and financial professionals revealed an average market risk premium of 5.5% in the United States, with a standard deviation of 1.7%. So there is considerable room for flexibility in choosing a market risk premium for Wal-Mart, but the company is tied closely to the economy as a whole, so the mean number of 5.5% is reasonable.

Slide 9: Asset-Specific Risk

Asset-specific risk is the third component of the capital asset pricing model. This reflects the added risk that the individual stock has. It is calculated by measuring the movements of that stock versus the movements of the market as a whole. The metric is known as the beta. The market has a beta of 1.0. A stock with a beta over 1 is more volatile than the market; a stock with a beta below 1 is less volatile than the market. Wal-Mart has a beta of 0.37, meaning it is much lower than the market as a whole.

Slide 10: CAPM and the Cost of Equity

Just to recap what the capital asset pricing model looks like:

When we plug in the three different components of risk, we will arrive at the cost of equity for Wal-Mart:

As you can see, the cost of equity for Wal-Mart is actually lower than its cost of debt, that is how stable the company's stock price is.

Slide 11: Wal-Mart's Capital Structure

Circling back to the weighted average cost of capital, we need to determine the capital structure for Wal-Mart. This can be done by looking at the company's balance sheet. The total value of the company is $198,825 billion. Of this, the total value of shareholders' equity is $80,535 billion. This means that equity comprises 40.5% of the capital structure for Wal-Mart. There are no preferred shares, so the remainder is debt, which is 59.5% of the capital structure.

Slide 12: Weighted Average Cost of Capital

To calculate the WACC, you take the weights for debt and equity and applies the costs of each:

Slide 13: Conclusions

Wal-Mart has an unusually low cost of capital. This is because the company has an unusually low cost of equity. With a very low beta, Wal-Mart equity is incredibly stable for investors, with risk nearly one-third of the market as a whole. This stability means that whether debt or equity, Wal-Mart's returns are very reliable. Indeed, recent upticks in the Treasury rates, even just since the company's most recent debt issue, have pushed the cost of debt above the cost of equity.