Essay Prompt Instructions:
Estimate the component capital costs and WACC for Rolls Royce plc.
Give an evaluation of the difficulties/problems encountered in arriving at your estimates.
(ITS A PRESENTATION EXERCISE, WILL YOU BE ABLE TO DO A POWERPOINT SLIDE INSTEAD OF ESSAY)
http://www.rolls-royce.com/~/media/Files/R/Rolls-Royce/documents/investors/annual-reports/Rolls-Royce_plc_Annual_Report_2015_WEB.pdf – rolls royce financial statement
The general formula for WACC is the weighted of the cost of equity plus the weighted cost of debt. The first step is therefore to calculate the weights of these two components. The company has assets of ₤24,065 (m) and liabilities of ₤17,776 (m). This gives a weight of 73.9% debt, and 26.1% equity.
The next step is to calculate the cost of debt. A year ago the company issues bonds due 2025 at 3.625%. This is the closest thing to a current bond yield that was available on the company’s bonds, and will be considered the cost of debt. The company’s financial situation has not changed much since the bonds were issues.
To calculate the cost of equity, we can use the capital asset pricing model. The formula for this is
Source :Investopedia (2016)
The Treasury bond rate can be considered the risk free rate. The 2 year Treasury has a yield of 0.08% (Bloomberg, 2016). The beta for Rolls Royce shares is 0.93 (Reuters, 2016). The expected market return is a 7% premium. So this gives us the follow cost of equity:
Re = .08 + (.93)(7) = 6.59%
Taking the cost of debt and cost of equity together, the weighted average cost of capital can then be calculated:
WACC = (.739)(3.625) + (.261)(6.59) = 2.68 + 1.72 = 4.4%
There are a couple of challenges in arriving at this. The first is finding the cost of debt. That would be easy if the company had a recent issue, but the most recent was one year ago. Further, you have to choose which time frame is most appropriate to examine. Ten year seems reasonable, but it may be more pragmatic to look at the duration of the debt and align your choice with that. The other problem with getting a cost of debt is finding a recent trade – not as easy as one might think – from which to pull a yield.
There were also challenges doing the CAPM calculation. There are many Treasuries to choose from – something that is a fairly close maturity, as there is less risk with shorter maturities, seems best. That is what was chosen here. But there is also the matter of the market risk premium. There is some conventional wisdom to the 7% number, but that number could likely be made more precise. Everybody will calculate that a little bit differently, and the market risk premium is seldom published.
Reuters (2016) Rolls Royce Holdings plc. Retrieved November 29, 2016 from http://www.reuters.com/finance/stocks/overview?symbol=RR.L
Rolls Royce plc 2015 Annual Report. Retrieved November 29 from http://www.rolls-royce.com/~/media/Files/R/Rolls-Royce/documents/investors/annual-reports/Rolls-Royce_plc_Annual_Report_2015_WEB.pd
Rolls Royce (2015) “Rolls Royce plc issues US bonds” Retrieved November 29, 2016 from http://www.rolls-royce.com/media/press-releases/yr-2015/pr-07a-10-2015-rr-plc-issues-us-bonds.aspx
“UK rates and bonds” (2016) Bloomberg. Retrieved November 29, 2016 from https://www.bloomberg.com/markets/rates-bonds/government-bonds/uk