- Introduction of Company
- Estimation of Risk-Free Rate
- Estimation of Equity Market Risk Premium
- Estimation of Cost of Equity Using CAPM
- Estimation of Cost of Debt
- Estimation of the WACC
- Explanation of WACC
- WACC for Valuing Foreign Subsidiary Projects
- References
Introduction of Company
The company selected for the estimation of its weighted average cost of capital is Bayerische Motoren Werke (BMW AG), which is listed on the Frankfurt Stock Exchange under the Xetro trading system. The company has its headquarters in Munich, Germany. It produces motorcycles, automobiles, and aircraft engines. In 2015, the company became the twelfth largest vehicle producer of motor vehicles in the world.
The company currently has 134,682 employees and 30 production locations in 14 countries around the world. It delivered a total number of 2.49 million automobiles to customers in 2018 and generated total revenue of EUR 97.48 billion. The company also has a strong motorsport history especially in sports cars, Formula 1, and touring cars (“BMW group key figures,” n.d.). In this report, analysis is performed to estimate the WACC for BMW AG and analyze its different components.
Estimation of Risk-Free Rate
The risk-free rate can be called a theoretical return on investments that have zero risks. A bund, on the other hand, is a debt security that is issued by the government in Germany and it is equivalent to the US treasury bonds. The yield of these bunds could be used as a risk-free rate. The German bund 10-year yield is 0.00% and the 30-year yield is 0.63% (“German rates & bonds,” n.d.). Since this is a long-term investment, the risk-free rate would be estimated to be at 0.63%.
Estimation of Equity Market Risk Premium
Equity market risk premium is the excess return generated by an investment at a risk-free rate. The current market risk premium in Germany is 8.32% (“Implied market-risk-premia (IMRP): Germany,” n.d.). Market return can also be estimated by adding the risk-free rate in the equity risk premium. The market return would be: 8.32% + 0.63% = 8.95%.
Estimation of Beta
The beta of a stock is the coefficient that measures the systematic risk or the volatility of the stock compared to the market’s overall unsystematic risk. The beta is an important variable that is used in the capital asset pricing model, especially the levered beta or beta equity. The current beta equity for the BMW stock is 0.80 based on 3 years of monthly returns (“Bayerische Motoren Werke Aktiengesellschaft (BMW.DE),” n.d.).
Estimation of Cost of Equity Using CAPM
The capital asset pricing model is used to compute the cost of equity. It cannot be calculated directly from financial statements like the cost of debt. This is because the cost of equity is the required rate of return for the equity holders and must be paid to them. The formula for the CAPM model is as follows:
Required Return (Ke) = Rf + (Rm – Rf) x Beta Equity
After all the required variables have been estimated for this model, the cost of equity can now be estimated as follows:
Ke = 0.63% + (8.32% x 0.80)
Ke = 7.29%
Estimation of Cost of Debt
The cost of debt is the interest costs or charges paid by a company on its debt obligations. Since the annual reports of BMW do not mention their average or current interest rate, an estimation can be done for the cost of debt. The total long-term debt for the company in 2018 was EUR 59705 million and the total interest costs were EUR 386 million (“Bayerische Motoren Werke AG: BMW,” n.d.). This provides the before-tax cost of debt of 386/59705 = 0.65%. The 5 year average tax rate for BMW has been equal to 31.71% (“Bayerische Motoren Werke AG (BMWG.DE),” n.d.). This gives us an after-tax cost of debt of 0.65% x (1-31.71%) = 0.44%.
Estimation of the WACC
Since the automobile business is highly capital intensive, these companies extensively make use of debt financing. The current debt to capital ratio for BMW is 63.63% and this means that the remaining portion of 1-63.63% = 36.37% is equity in the capital structure. This shows that the company has 1/3 of equity and 2/3 of debt financing in its capital structure. Using these proportions, the WACC can now be estimated as follows:
WACC = (Ke x E%) + (Kd x D%)
WACC = (7.29% x 36.37%) + (0.44% x 63.63%)
WACC = 2.93%.
The computations have also been performed in the excel spreadsheet and these are summarized in the table below:
Table 1: BMW WACC
Explanation of WACC
Companies evaluate and appraise their projects through capital budgeting, and one of the most important investment tools in capital budgeting is the WACC. When the valuation of investments is performed, the WACC is used by security analysts to value them. WACC also plays a crucial role in the value of a business. All the free cash flows from the business are discounted back at its WACC to calculate the present value of the free cash flow and the resulting value of the business. Furthermore, economic value-added calculations also require the use of WACC in its formula.
WACC serves as the reality check for all the projects and investments of the firm. WACC incorporates the risk of an investment and the level of the risk faced by the firm, and utilizing this combination, gives the NPV value. The NPV then shows whether the respective project generates wealth or it can destroy it. Other important uses of WACC are in the EVA computations, valuation of mutually exclusive projects with the same or different levels of risk, and other investment decisions.
WACC for Valuing Foreign Subsidiary Projects
An MNC that wants to evaluate the projects of its foreign subsidiaries must use a different WACC and should not use the WACC of its parent company. This is because of the level of the risk of the parent company and because its subsidiaries are operating in different countries. Also, if the foreign subsidiary obtains all the financing for its projects from its sources, then the MNC must compute its foreign cost of capital to reflect the same level of risk as shown by the project. Other specific factors, like country risk, market risk premium, and exchange rate, also have an impact on the MNC’s foreign operations. Therefore, it is feasible to compute WACC for valuing projects.
References
- BMW group key figures. (n.d.).
- Bayerische Motoren Werke AG: BMW. (n.d.).
- Bayerische Motoren Werke AG (BMWG.DE). (n.d.). Web.
- Bayerische Motoren Werke Aktiengesellschaft (BMW.DE). (n.d.). Web.
- German rates & bonds. (n.d.). Web.
- Implied market-risk-premia (IMRP): Germany. (n.d.). Web.