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Cost of Debt
The cost of debt is the effective rate that a company pays on its total debt.
As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.
1. Cost of debt (before tax) = Corporate Bond rate of company’s bond rating.
Pepsico 2.75% = 2.75%
Current cost of Debt as of February 17th 2014 = 2.75%
2. Current tax rate
In 2013 PepsiCo’s tax rate was = 23.66%
2013 PepsiCo averaged tax rate of 23.66%
3. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 – Tax Rate)
The effective rate that a company pays on its current debt after tax.
.0275 x (1 – .2366) = Cost of debt after tax
The cost of debt after tax for PepsiCo is 2.10%
Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return – Risk Free Rate)
The cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing in their company.
Risk Free Rate = U.S. 10-year bond = 2.74%
Average Market Return 1950 – 2014 = 7%
Beta = PepsiCo’s Beta = 0.37
Risk Free Rate + Beta Equity (Average Market Return – Risk Free Rate)
2.74 + 0.37 (7- 2.74)
2.74 + 0.37 x 4.26
2.74 + 1.58 = 4.31%
Currently, PepsiCo’s has a Cost of Equity or R Equity of 4.31%, so investors should expect to get a return of 4.31% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.
Weighted Average Cost of Capital or WACC calculation
The WACC calculation is a calculation of a company’s cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.
As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:
Tax Rate = 23.66%
Cost of Debt (before tax) or R debt = 2.75%
Cost of Equity or R equity = 4.31%
Debt (Total Liabilities) for 2013 TTM or D = $53.069 billion
Stock Price = $78.09 (Feb. 17th, 2014)
Outstanding Shares = 1.55 billion
Equity = Stock price x Outstanding Shares or E = $121.04 billion
Debt + Equity or D+E = $174.109 billion
WACC = R = (1 – Tax Rate) x R debt (D/D+E) + R equity (E/D+E)
(1 – Tax Rate) x R debt (D/D+E) + R equity (E/D+E)
(1 – .2366) x .0275 x ($53.069 /$174.109) + .0431 ($121.04 /$174.109)
.7634x .0275 x .3048 + .0431 x .6972
.0064 + .03
= 3.64%
Based on the calculations above, we can conclude that PepsiCo pays 3.64% on every dollar that it finances, or 3.64% cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0673 plus the cost of the investment for the investment to be feasible for the company.
Understanding the WACC of a company is important because securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a business’s net present value.
Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let’s say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company’s return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.
