The analysis will present the suitable beta rate to be used in assessing the cost of equity. The evaluating company is Henkel AG, which has presence in both Germany and the USA. Therefore, the analysts might be confused with the different rate of treasury and might not use the appropriate risk free rate while evaluating the cost of capital of the business. According to Kianpoor and Dehghani(2016), risk free rate is normally based on the 10 years Treasury bond yield of the US government. However, the establishment of the company becomes a factor as the treasury rate of different countries are different. Further, the change in the T-bill rate might change the target cost of capital for the management. The report will present the details measurement of cost of capital using capital asset pricing model. Further, the cost of debt was also measured in this analysed report for Henkel AG. The required method of measuring the cost of debt is to add the premium rate based on the credit rating. Further, the tax rate on income of the company was deduced by evaluating the tax reconciliation from the annual report. In this report, the effective tax rate on the income of Henkel AG will be measured too. Additionally, the weighted average cost of capital of will be measured for the company of given period.
Cost of capital
Cost of capital (Re) can be said as the opportunity cost which can be said as a desired value for measuring before any investment. It calculates the rate of return that could have been earned in investing in a different instruments in the market with similar level of risk. As such, (Re) is the rate of return that can be measured by the investor in making an investment. The cost of capital is dependent on the type of financing used. It can be classified into two kinds which are- cost of equity as well as debt. In global financial, business corporate houses use a combination of debt and equity to provide external financing to the business (Campbell et. al. 2012). In such a scenario, the Re is obtained firm the WACC. In the capital budgeting process, the cost of capital is a barrier that the brand must cross, in order to achieve sales revenue and profits.
CAPM
The CAPM model evaluates therisk and expected return from the investment in the projects. It is widely used in valuing securities. As per the CAPM model, the estimated return on a portfolio or security is equal to the value available on risk free security along with the risk premium (Zabarankinet al. 2014). In finance, the security market line gives the results of CAPM at various market risk. By using the CAPM model, the estimated return on a stock can be calculated
The capital asset pricing model can be stated as empirical , and facilitates the determination of the rate of return on the assets of an organization , (author ) mentioned that if the asset is established as a wide portfolio , considering the assets static risk.
The CAPM model represent the assets sensitivity to a potential risk that cannot be diversified. This is represented by beta in the financial industry. Júnioret al. (2015) stated that Utility functions or changeable asset returns where the distribution of probability are defined by the first two moments (Example – Normal distribution ) and null transactional expenditures. The CAPM model is relevant in the global financial market, despite the existence of more effective approaches to asset pricing and portfolio choosing (Merton’s portfolio problem and arbitrage pricing theory).
Re- Lever and Unlevered Beta
WACC is constituted of both re- lever and unlevered beta and requires both for calculation of market risk (Campbell et al., 2015). For delivering beta WACC is examined by usage of the cost relating to equity and debt in equivalent proportions. For both re levered and unlevered beta WACC is reduced as per the lowest level, which leads to enhancing shareholders wealth.
For unlevered data, the cost of debt shall be attained in the bonds’ yield. The levered data is constituted of two risks which are business risk and financial risk. Maio (2013) stated that business risks represents uncertainty in the projection of operating profit, and apprehension in the investment necessities. Business risk facilities uncertainty in operating profit and capital investment characteristics. On the other hand, financial risk evaluates risk associated with the investment made by the shareholdersto facilitate decision made by the managers to reduce the financial leverage. Moussa et al. (2014) mentioned that this happens due to the complementation of additional debts to the firm
The capital structure may consist of entirely by the equity, the beta of that company may show the risk of business only. Maio(2011) mentioned that such beta can be known as asset beta. In the case of unlevered beta, a weighted average beta can be obtained using weights on prorate basis of the assets used in the firm’s instruments of investment. The weighted unlevered beta as obtained from the financial structure in the company is used to evaluate equity as well as levered beta in the firm. These two betas are the predictor of market risk as well as the business risk associated with the activities of the firm, but also the financial risk of the concerned parties,
The following relationship can be obtained for determining the relationship between levered and re-levered betas.
Levered Beta = Unlevered Beta * (1+D/E), where D/E = Debt-to-Equity Ratio of the company (Cornaggia and Cornaggia 2013).
It is assumed that the practioner’s procedure makes certain assumptions about corporate debt having less risk
The treasury rate of the country is the risk free rate of the economy (Lee, Tsai and Lee 2013). The rate itself suggests that investing in the treasury bonds issued by the government of a country does not fail mainly. The US treasury bonds have not failed yet (Chordia, Subrahmanyam and Tong 2014). Thereby, analysts present in the market might find the treasury rate as suitable to assume the treasury rate as risk free rate. The risk free rate is basically in line with the internal rate of inflation and change in the valuation of the assets. In addition to this, the risk free rate just provides the nominal rate of interest. The expected rate of interest from any assets is more than the risk free rate (Crockett and Duffy 2013). Some people also state risk free rate of an investment as the guaranteed return of the investment (Guimarães, Kingsman and Taylor 2013). The cost of equity is measured by adding risk free rate with the risk premium of an investment. Change in the risk free rate may change the risk premium for both equity and debt of the business. Zhang (2014) found that increase in risk free rate may increase the risk premium of the investment. Thereby, we may see that risk free rate has the features of no default risk as well as no reinvestment risk (Crockett and Duffy 2013).
The measurement of risk free rate in the excel sheet showed that the US and European Treasury bond were not same. The different rate of risk free interests were seen in the calculation. The change in the yield rate of treasury bonds of different periods would have different interest rates (Krishnamurthy and Vissing-Jorgensen 2012). The maximum terms of bond was of 20 years while the minimum of 1 year was considered in this case study. The graph of the US and Euro denominated bonds can be observed in the following figure where the volatility of the US bond is higher than the Euro bond. The rate of volatility is the measurement of risk (Huang and Huang 2012). Therefore, it will be suitable for the management and the analyst to select the Treasury rate of Euro bond to consider as the risk free rate. However, the short-term rate of Treasury bond was lower than the long-term bond. The interest rate of long-term such as 20 year, Euro bond has interest rate of 1.724%. Therefore, the risk free interest rate can be considered as the long-term yield from a bond. The analysts must consider 20 year’s bond rate in valuing a company or its assets (Hancock and Passmore 2014). It would provide the analysts to value the company for the next twenty years.
The beta measurement can be seen in the following tables where the levered beta of all the company was prepared using the MSCI index of the respective countries of the listings. Further, the beta was unlevered by reducing the debt-equity ratio of the respective company. The average of all the unlevered beta was transformed into levered beta of the company. The levered beta of Henkel was measured by adding the debt-equity ratio again with average value of the unlevered beta of the market (Sundaresan 2013).
The market risk premium was assumed 5% for Henkel AG. The rate was higher than the risk free rate of ten years bond rate. The cost of equity of the company has been measured using 5% risk premium rate. The value of cost of equity is 4.63% for the period of 20 years. In this way, the cost of equity was derived for Henkel AG.
The cost of debt is one of the important construct of capital structure where cost of capital nominates it as the crucial part of the capital. It other words it is an efficient rate that an organization pays on its current debt (Krishnamurthy and Vissing-Jorgensen 2012). This can be ascertained in either after or before the tax returns. However, the after tax is cost is often used because interest expense is deductable. For determining the cost of debt, the yield rate of the bond can be applied. The yield to maturity is all about discount rate at which the value of the bond would be equal to the composite figure of all future cash flows from the bond. According to Duffee (2014), Treasury yield is the rate of interest, the U.S government pays to borrow money for separate lengths of time. However, many researchers argued that treasury yields not just influenced the money that needs to be paid by the government to borrow and the determination of the investor’s earning in this debt, but it also authorize the individual’s rate of interest and business pays to borrow money to buy real estate (Hancock and Passmore 2014). If the enterprise has bonds outstanding and traded the bond as well, the yield to maturity and straight bond can be used as the rate of interest on the long term basis.
|
task 2 |
|
|
cost of debt [long-term] |
2.790 |
|
cost of debt [10 years] |
2.659 |
|
cost of debt [1 year] |
2.022 |
|
cost of debt [5 year ] |
4.1 |
Table 1: Cost of debt for different periods
(Source: Created by author)
From the above table, we can see the cost of debt of different periods. The long-term cost of debt was higher than the short-term cost of debt as seen from the table 1. The long-term treasury rate is suitable to determine the cost of debt. However, the cost of debt can be measured by processing the 10 years and 5 years of data. However, there was not enough data present in the previous measurement as rate of bond was not present. The cost of debt of 5 years was required in solving the problem as Henkel AG did not carry debt more than 5 years. Therefore, the measurement of cost of debt was prepared using the 5 years’ bond rate of return.
The application of credit agency is significant for the payers in the financial market because they are deeply relying on the opinion provided by the rating agencies regarding creditworthiness of an enterprise or a security (Billett, Hribar and Liu 2015). Companies hardly issues debt without assessing the previous assessment of its credit quality report provided by the rating agencies. All information supplied by the credit agencies are publicly disclosed and embody the judgment of experienced and most likely well knowledgeable researchers. Yield to maturity derived from the fixed income securities are correlated to credit rating. The lower yields represents those securities which are well established in the market than the poor rated securities. Baghai, Servaes and Tamayo (2014), signifies the current research opinion is displayed the overall capacity of the obligators which is applied for meeting the financial commitments. They also argued with fact that those viewpoints cover the overall capacity and objective to meet the financial commitments as it comesafterwards. Therefore this is not applied for a specific financial obligation. According to Cornaggia and Cornaggia (2013), opinion provided by the credit rating agencies have disclosed the ability of entities to honor senior financial obligations, which are made of the unsecured securities. However, the country risk factors are also incorporated by their credit agencies. Higher default probability have been noticed by the external obligations than domestic obligations and therefore the agencies are able to provide rating in both local currencies and foreign currencies. Generally, the rating of foreign currency of a particular obligor is lower than the rating of local currency.
Furthermore, the opinions provided by the agencies are comprised with qualitative and quantitative information furnished by the reliable resources or the obligor. The credit rating is changed with the changes of information. If agencies are not found any information, they may withdraw or suspend the credit ratings. According to Billett, Hribar and Liu (2015), the application of credit rating agencies in determining cost of debt is vast because not only it evaluates the business and financial risk of the entities, but also covers the capital structure, coverage ratios of cash flows, profitability, financial flexibility and so on. However, some companies are not willing to get rated. On the other hand, when there is no rating is available to ascertain the cost of debt, two alternatives are available in the market: History of recent borrowings and Synthetic rating estimation. There are many non-rated firms in the financial market, which borrows money from banks and other financial institutions. By analyzing, the recent borrowing history made by the enterprise, can get a sense of the types of default spreads being charged the entity and use this spreads with the estimated values of cost of debt. On the other hand, non-rated companies are assigned rating based on the financial ratios. This method is called synthetic rating. However, the role of the credit rating agencies is more impactful for the determination of cost of debt compare to other estimating methods.
Marginal tax rate is a part of tax, which is derived from an additional dollar of income. With the increase of income, the marginal tax rate for an individual tends to increase. Tax systems that employ marginal tax rates applies different rates of tax to different levels of income. As per the schedule of marginal tax, income is not taxed at one rate. It has been taxed at various level of income. According to Skrepnek, Thompson and Johnson (2015), if the taxpayer earns more money and move towards the higher of income, the rate of marginal tax can remarkable reduce the benefits of the additional income because that additional income will be taxed at a higher rate. Therefore, the marginal tax significantly influences the individual income.
|
Tax reconciliation |
2009 |
|
Current tax expense |
259 |
|
Add: adjustment from prior year |
20 |
|
Deferred tax income |
-47 |
|
Deferred tax income for change in tax |
-3 |
|
Increase in valuation |
13 |
|
Income tax |
242 |
|
EBT |
885 |
|
PAT |
643 |
|
Tax rate |
27.34% |
Table 2: Marginal tax rate
(Source: Created by author)
The tax reconciliation can be seen in the above table. The current tax expenses was not the current cost of tax as some of the reconciliation was necessary in this case. The reconciliation has shown that assessable income tax was lower than the paid tax in 2009. The paid tax was EURO 242 million. The effective tax rate was 27.34% on the assessed income.
Weighted average cost of capital is the measurement of the cost of equity combining the cost of debt and equity. The portion of cost of debt has an overall effect on the cost of capital of a business (Zhang 2014). Thereby, it is a normal process to consider the weighted average of both cost of debt and equity while measuring the cost of capital.
|
WACC measurement 4 |
|
|
market value of firm’s equity |
13445.23463 |
|
market value of firm’s debt |
8820 |
|
cost of equity |
4.626878078 |
|
cost of debt [5 years] |
4.106 |
|
equity financing ratio |
0.603866739 |
|
debt financing ratio |
0.396133261 |
|
corporate tax rate |
27.34% |
|
cost of capital |
4.42 |
Table 3: WACC measurement
(Source: Created by author)
References:
Baghai, R.P., Servaes, H. and Tamayo, A., 2014. Have rating agencies become more conservative? Implications for capital structure and debt pricing. The Journal of Finance, 69(5), pp.1961-2005.
Billett, M.T., Hribar, P. and Liu, Y., 2015. Shareholder-manager alignment and the cost of debt. Available at SSRN 958991.
Campbell, J.Y., Giglio, S., Polk, C. and Turley, R., 2012. An intertemporal CAPM with stochastic volatility (No. w18411). National Bureau of Economic Research.
Chordia, T., Subrahmanyam, A. and Tong, Q., 2014. Have capital market anomalies attenuated in the recent era of high liquidity and trading activity?.Journal of Accounting and Economics, 58(1), pp.41-58.
Cornaggia, J. and Cornaggia, K.J., 2013. Estimating the costs of issuer-paid credit ratings. Review of Financial Studies, 26(9), pp.2229-2269.
Crockett, S. and Duffy, J., 2013. An experimental test of the lucas asset pricing model. Unpublished manuscript.
Duffee, G.R., 2014. Expected inflation and other determinants of Treasury yields. Johns Hopkins University, Department of Economics Working Paper.
Guimarães, R.M., Kingsman, B.G. and Taylor, S. eds., 2013. A reappraisal of the efficiency of financial markets (Vol. 54). Springer Science & Business Media.
Hancock, D. and Passmore, S.W., 2014. How the Federal Reserve’s Large-Scale Asset Purchases (LSAPs) Influence Mortgage-Backed Securities (MBS) Yields and US Mortgage Rates.
Huang, J.Z. and Huang, M., 2012. How much of the corporate-treasury yield spread is due to credit risk?. Review of Asset Pricing Studies, 2(2), pp.153-202.
Júnior, W.F.B., Almeida, G.L., Ribas, C.A., RibasFilho, J.M. and De Cobelli, O., 2015. EORTC Risk Model to Predict Progression in Patients With Non–Muscle-Invasive Bladder Cancer: Is It Safe to Use in Clinical Practice?.Clinical genitourinary cancer. 08-517.
Kianpoor, M.M. and Dehghani, A., 2016. The Analysis on Fama and French Asset-Pricing Model to Select Stocks in Tehran Security and Exchange Organization (TSEO). Procedia Economics and Finance, 36, pp.283-290.
Krishnamurthy, A. and Vissing-Jorgensen, A., 2012. The aggregate demand for treasury debt. Journal of Political Economy, 120(2), pp.233-267.
Lee, C.F., Tsai, C.M. and Lee, A.C., 2013. Asset pricing with disequilibrium price adjustment: theory and empirical evidence. Quantitative Finance, 13(2), pp.227-239.
Maio, P., 2013. Intertemporal CAPM with conditioning variables.Management Science, 59(1), pp.122-141.
Moussa, A.M., Kamdem, J.S., Shapiro, A.F. and Terraza, M., 2014. CAPM with fuzzy returns and hypothesis testing. Insurance: Mathematics and Economics, 55, pp.40-57.
Skrepnek, G.H., Thompson, T.C. and Johnson, E.J., 2015. Debt and taxes: Marginal tax rate changes, capital structure, and innovative activity in the biotechnology sector. Journal of Commercial Biotechnology, 21(1).
Sundaresan, S., 2013. A review of Merton’s model of the firm’s capital structure with its wide applications. Annu. Rev. Financ. Econ., 5(1), pp.21-41.
Zabarankin, M., Pavlikov, K. and Uryasev, S., 2014. Capital asset pricing model (CAPM) with drawdown measure. European Journal of Operational Research, 234(2), pp.5
Zhang, L., 2014. Exploring Asset Pricing Anomalies. NBER Reporter, 2014 (1), p.17.
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