In analyzing a company’s cost of debt, current tax rate, cost of equity and WACC, we will get an understanding of the company’s financial risk, and future ratings. Based on this analysis a shareholder will be able to calculate an expected return over the long-term for their investment. In this article I will look at Baytex Energy’s (BTE:TSX) cost of debt, tax rate, cost of equity and WACC to calculate an expected return from this point.

**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 metric is useful, because 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.

*8. Cost of debt (before tax) = Corporate Bond rate of company’s bond rating.*

- S&P rated Baytex Energy bonds “BB”
- Baytex Engy Tr 9.15% Rate of “BB” = 9.15%
- Current cost of Debt as of January 17th 2013 = 9.15%

According to the S&P rating guide, the “BB” rating is – “Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.” Baytex Energy has a rating that meets this description.

*9. Current tax rate (Income Tax total / Income before Tax)*

- 2008 – $26 million / $289 million = 9.00%
- 2009 – $(19) million / $68 million = -27.94%
- 2010 – $(24) million / $154 million = -15.58%
- 2011 – $52 million / 270 million = 19.26%
- 2012 TTM – $135 million / $420 million = 32.14%

As the variations over the past 5 years are so great I will use the tax rate of the years Baytex paid income tax. 2008, 2011 and 2012 TTM tax rate = 20.13%

Baytex Energy has averaged a tax rate of 20.13%.

*10. 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.

- .0915 x (1 – .2013) = Cost of debt after tax

The cost of debt after tax for Baytex Energy is *7.31%*

**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, for example, shareholders, to compensate for the risk they undertake by investing in their company.

- Risk free rate = U.S. 10-year bond = 1.88% (Bloomberg)
- Average market return 1950 – 2012 = 7%
- Beta = (Google Finance) Baytex Energy’s beta = 1.51

Risk free rate + Beta equity (Average market return – Risk free rate)

- 1.88 + 1.51 (7-1.88)
- 1.88 + 1.51 x 5.12
- 1.88 + 7.73 = 9.61%

Currently, Baytex Energy has a cost of equity or R Equity of 9.61%, so investors should expect to get a return of 9.61% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

(*Please note that this is the CAPM approach to finding the cost of equity. Inherently, there are some flaws with this approach and that the numbers are very “general.” This approach is based off of the S&P average return from 1950 – 2012 at 7%, the U.S. 10-year bond for the risk-free rate which is susceptible to daily change and Google finance beta.*)

**Weighted Average Cost of Capital or WACC**

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 states 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 = 20.13% (Baytex Energy 2008, 2011 and 2012 TTM Tax Rate)

Cost of Debt (before tax) or **R debt** = 9.15%

Cost of Equity or **R equity** = 9.61%

Debt (Total Liabilities) for 2012 TTM or **D** = $1.347 billion

Stock Price = $44.40 (January 17th, 2013)

Outstanding Shares = 121.22 million

Equity = Stock price x Outstanding Shares or **E** = $5.382 billion

Debt + Equity or **D+E** = $6.729 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 – .2013) x .0915 x ($1.347/$6.729) + .0961 ($5.382/$6.729)

.7987 x .0915 x .2001 + .0961 x .7998

.0146 + .0758=

9.04%

Based on the calculations above, we can conclude that Baytex Energy pays 9.04% on every dollar that it finances, or 9.04 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0904 plus the cost of the investment for the investment to be feasible for the company.

**Summary**

Currently Baytex Energy has a bond rating currently stands at “BB,” this states that the company bonds are “Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.” Please note that a bond rating of “BB” is considered “speculative”.

The CAPM approach for cost of equity states that shareholders need 9.61% average per year over a long period of time on their equity to make it worthwhile to invest in the company. This calculation is so based on the average market return between 1950 and 2012 at 7%.

The WACC calculation reveals that the company pays 9.04% on every dollar that it finances. As the current WACC of Baytex Energy is currently 9.04% and the beta is slightly above average at 1.51, this implies that the company needs at least 9.04% on future investments and will have above average volatility moving forward.

The above analysis of Baytex Energy indicates a significant amount of risk for the investor. The Bond rating of “BB” by Standard & Poor’s indicates that the company bonds are “speculative”. The rating of “BB” states “”Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.” The WACC reveals that Baytex Energy has the ability to add future investments and assets at around 9.04%.

As the CAPM indicates, the investor needs 9.61% return so, if you believe that you can get 9.61% year over year over the long term on this investment then you will get good value on your investment.

To read more on Baytex energy please read: BTE – Baytex Energy Corp. (BTE-TSX, BTE-NYSE) Stock Price Target 2012

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