Estimating Walmart’s Cost of Capital 1

I. Introduction:

Estimating Walmart’s Cost of Capital

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 Estimating Walmart’s Cost of Capital 2

II. Cost of Capital (Definition & Importance)

Answer:

Cost of Capital - Definition:

The cost of capital is the cost at which the company is financing its overall operations. For a

company, it can be either cost of equity or the cost of debt or a weighted average of both the

costs of equity and debt.

For a prospective investor in a company or a capital budgeting project, the cost of capital is

the required rate of return that will make the project viable for investment.

Importance of Cost of Capital:

The cost of capital is a very important phenomenon in finance and other disciplines. Below

are its few important benefits:

i. Formulation of the Desired Financial Structure:

One of the importance of the cost of capital is the knowledge of optimal financial or capital

structure required to fund the company’s overall operations and activities. It gives you the

desired mix of equity and debt needed for the company.

If a company wants to finance its operations only through equity (own money) then the cost

of capital will only be the cost of equity, but if the company decides to use debt as well for

the financing of the company. Then the cost of capital will be calculated as a weighted

average of both the cost of equity and debt.

So, that cost of capital is always an important factor in that decision of formulating a desired

and optimal financial structure.

ii. Appraisal of Investment or Capital Budgeting Project:

Estimating Walmart’s Cost of Capital 3

The other important usage of cost of capital is using it as a financial standard for the appraisal

and evaluation of a capital budgeting project or an investment.

It is used as a discount factor to find out the net present value (NPV) of future estimated cash

flows from that project. If the NPV results in a positive value then the investment is deemed

to be viable and profitable.

In other words, the proposed investment or project will provide sufficient returns to cover the

available cost of capital to be used to finance the investment and project. Similarly, a

negative NPV will tell that the investments’ net future cash flows are insufficient even to

cover the cost of capital available for financing.

iii. Evaluation of Managements’ Financial Performance:

Cost of capital is also used as a measure to evaluate the financial performance of a company’s

management. It is done by comparing the actual profitability of a project with the company’s

cost of capital.

If the results are better than the required cost of capital, then it illustrates the satisfactory

performance of the company’s management and if the results are lesser than it then the

company’s management performance is questionable.

III. Before Tax Cost of Long-Term Debt:

Answer:

2019 $ Millions

Interest Expense 2,129

Short Term Borrowings 5,225

Current Portion of Long-Term Debt & Capital Leases 2,605

Estimating Walmart’s Cost of Capital 4

Long-Term Debt & Capital Leases 50,203

Total Interest-Bearing Debt 58,033

Before Tax Cost of Total Debt = Interest Expense / Total Interest-Bearing Debt

Before Tax Cost of Total Debt = 2,129 / 58,033 = 3.67%

The prime rate is 5.5 percent. The average interest rate on Short term borrowings or 3-months

commercial papers is 2.73 percent. The effective annual rate will be (1+0.0273)4 – 1 = 11.4%

So, an average interest rate for short term borrowings, assuming that both the components i.e.

commercial papers and other short-term borrowings are in equal proportion, will be

(5.5+11.4)/2 = 8.5%

So, the annual interest expense for short term borrowings will be (5,225 x 8.5%) $444.

And after deduction of interest on short term borrowings, net interest on long term debt will

be (2,129 – 444) $1,685 Million.

Now to calculate after-tax cost of long-term debt will be:

2019 $ Millions

Interest Expense 1,685

Current Portion of Long-Term Debt & Capital Leases 2,605

Long-Term Debt & Capital Leases 50,203

Total Long-term Debt 52,808

Estimating Walmart’s Cost of Capital 5

Before Tax Cost of Long-term Debt = Interest Expense / Total Long-term Debt

Before Tax Cost of Long-term Debt = 1,685 / 52,808

Before Tax Cost of Long-term Debt = 3.19%

IV. After-Tax Cost of Long-Term Debt:

Answer:

a)

2019 $ Millions

Income Tax Expense 4,281

Income Before Taxes 11,460

Effective Tax Rate 4,281 / 11,460 = 37.35%

After Tax cost of Long-term Debt = Before Tax Cost of Debt x (1 – Tax)

After Tax cost of Long-term Debt = 3.19% (1 – 0.3735)

After Tax cost of Long-term Debt = 1.99%

b)

The discussion between Dale & Lee tells us that corporate tax rates have been reduced by US

Tax regulations and the new rate is 21 percent. And a recent press release accompanying

Walmart’s quarterly returns tells the anticipated effective tax rate of around 27 percent. But
Estimating Walmart’s Cost of Capital 6

actual effective tax rate for the year 2019, as calculated above is 37.35 percent. It has been

used to calculate after-tax cost of debt.

V. Short-term borrowings in cost of debt:

Answer:

A company usually has two types of debts. 1 Long term borrowings, usually availed for long

term growth plans of the company. These are usually in the form of long terms bonds and

debentures with a maturity of more than a year. While the company uses short term bank

loans and commercial papers for carrying out routine operations of the business.

Both the components are important in the calculation of the cost of debt, therefore the cost of

debt for both long-term and short-term loans or debt is used for the calculation of the total

cost of debt.

The short-term borrowings are used to finance the operations, make capital expenditures, and

fund other cash requirements of the company. So, it is important to include these while

calculating the cost of total debt. Because these form an important part of the company’s

capital.

Therefore, it has already been included in total debt while calculating the total cost of debt

above i.e. 3.67%.

VI. Cost of Equity using Gordon Dividend Growth Model:

Answer:

Dividend Payout Ratio = Dividend per Share / Adjusted Earnings per share

Dividend Payout Ratio = 2.08 / 4.91 = 0.42

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Estimating Walmart’s Cost of Capital 7

Sustainable Growth Rate = Return on Equity x (1 – Dividend Payout Ratio)

Sustainable Growth Rate = 8.9% x (1 – 0.42) = 5.2%

Net year dividend is approximated as $2.08 x 1.052 = $2.19

Now calculate Cost of Equity using Gordon Dividend Growth Model

Cost of Equity = (Next years’ Dividend / Current Share Price) + Growth Rate

Cost of Equity = (2.19 / 102.2) + 5.2% = 7.3%

VII. Cost of Equity using Capital Asset Pricing Model (CAPM):

Answer:

Cost of Equity =

Risk Free Rate of Return + Beta x (Market Rate of Return – Risk Free Rate of Return)

Risk Free Rate of Return = 10 Year Treasury Bond (Geometric Avg 1928-2018) = 4.83%

Market Rate of Return = S&P 500 (Geometric Avg 1928-2018) = 9.49%

Adjusted Beta = 0.71

So, Cost of Equity using Capital Asset Pricing Model (CAPM)

Cost of Equity = 4.83% + 0.71x (9.49 – 4.83)

Cost of Equity = 4.83% +3.31%

Cost of Equity = 8.14%

VIII. Weights for Weighted Average Cost of Capital (WACC):

Answer:

1. Using Book Value:

Estimating Walmart’s Cost of Capital 8

Book value of Equity = $79,634 Million

Cost of Equity using CAPM = 8.14%

Book Value of Total Debt (from above) = $58,033 Million

Pre-tax cost of total debt (from above) = 3.67%

After Tax cost of total debt using effective rate of tax = 3.67% x (1 – 0.3735) = 2.3%

Total Value of Equity + Debt = $137,667 Million

WACC =

(Equity / Total Equity + Debt) x cost of Equity + (Debt / Total Debt + Equity) x cost of Debt

= (79,634 / 137,667) x 8.14% + (58,033 / 137,667) x 2.3%

= 0.58 x 8.14% + 0.42 x 2.3%

= 0.047 + 0.009

= 5.6%

2. Using Market Value:

Market Value of Equity = Number of Outstanding Shares x Share Price

Market Value of Equity = 2,495 x $102.2 = $254,989 Million

Cost of Equity using CAPM = 8.14%

Market Value of Long-Term Debt (Estimated) using Bonds information =

(Interest Expense [(1 – (1/((1 + Cost of Debt)^Maturity)))/Cost of Debt] + [Future Value of

Debt/((1 + Cost of Debt)^Maturity)]

= 1,685[(1 – (1/((1 + .0199)^11)))/.0199] + [52,808/((1 + .0199)^11)]

Estimating Walmart’s Cost of Capital 9

= $59,018

Total Market Value of Equity + Debt = 254,989 + 59,018 = $314,007

WACC =

(Equity / Total Equity + Debt) x cost of Equity + (Debt / Total Debt + Equity) x cost of

Long-term Debt

= (254,989 / 314,007) x 8.14% + (59,018 / 314,007) x 1.99%

= 6.6% + 0.37%

= 6.97%

IX. Comparison with other WACC:

Answer:

It can be compared in two ways. 1. Being Walmart 2. Being a potential Investor

WACC calculated using book values is more reliable due to less use of estimations. It is

5.67% for Walmart.

Being Walmart, the target company having WACC of 4.3% is performing efficiently, as the

cost of its capital is lower than Walmart. And being a potential investor, it shows that the

target company is not viable for investment as compared to Walmart, as it has lower current

WACC then Walmart. So, Walmart is more viable for investment as it is providing better

returns 5.67% on its invested capital as compared to our target 4.3%.

Being Walmart, Walmart is performing efficiently as compared to Amazon, as its capital is

costing lower than Amazon. On the other hand, being investor, if Walmart’s WACC is

compared with Amazon’s WACC of 8%, then it shows that Amazon is more viable for
Estimating Walmart’s Cost of Capital 10

investment, as it is providing better return to its investors (both equity & debt) of 8% than

Walmart of 5.67%.

X. Learning from WACC:

Answer:

A company has two main sources of finance for its operations. 1. Equity & 2. Debt

Both the components bear some cost. Where debt cost is the interest that is paid on the debt,

cost of equity is a bit more complex calculated using various models. The most popular are

Gordon Dividend Growth Model & Capital Asset Pricing Model.

The cost of both the components i.e. Equity & Debt are weighted to give a Weighted Average

Cost of Capital (WACC). This WACC is a very important factor for both the company itself

and the potential investors, who want to invest in the company through shares or debt

instruments.

For the company, it tells us that what is the cost company is bearing to finance its operations

with the current mix of equity and debt and for an investor WACC is the expected return

from the company for investment.

So, if someone wants to invest in a company than it will have to make sure that its own cost

of capital (WACC) must be less than the expected returns (WACC) of the target company to

get gain on investment. The investors can do this by discounting the expected cash flows

from the target investment using its available WACC as discount factor. So, WACC has dual

nature in this sense.

Estimating Walmart’s Cost of Capital 11