Understanding Royal Dutch Shell’s (NYSE:RDS.A) cost of debt, cost of equity and WACC is an important factor in stock research. Using these formulas an investor will understand how much the shareholder should expect in return for the stock over the long-term, how much the company pays for its debt and how much the company needs in return to break even on its investments.
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.
8. Cost of debt (before tax) = Corporate Bond rate of company’s bond rating.
- S&P rated Royal Dutch Shell’s bonds “AA“
- Current 20-year corporate bond Rate of “AA” = 4.37%
- Current cost of Debt as of January 17th 2014 = 4.37%
According to the S&P rating guide, the “AA” rating is – “Very strong capacity to meet financial commitments.” Royal Dutch Shell has a rating that meets this description.
9. Current tax rate
- 2013 TTM – = 46.45%
2013 TTM Royal Dutch Shell has averaged tax rate of 46.45%
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.
- .0437 x (1 – .4645) = Cost of debt after tax
The cost of debt after tax for Royal Dutch Shell is 2.34%
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 = 2.83% (Bloomberg)
- Average Market Return 1950 – 2014 = 7%
- Beta = (Google Finance) Royal Dutch Shell’s Beta = 1.08
Risk Free Rate + Beta Equity (Average Market Return – Risk Free Rate)
- 2.83 + 1.08 (7- 2.83)
- 2.83 + 1.08 x 4.17
- 2.83 + 4.50 = 7.33%
Currently, Royal Dutch Shell has a Cost of Equity or R Equity of 7.33%, so investors should expect to get a return of 7.33% 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 – 2013 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 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 = 46.45%
Cost of Debt (before tax) or R debt = 4.37%
Cost of Equity or R equity = 7.33%
Debt (Total Liabilities) for 2013 TTM or D = $175.466 billion
Stock Price = $70.57 (Jan, 17th 2014)
Outstanding Shares = 3.14 billion
Equity = Stock price x Outstanding Shares or E = $221.590 billion
Debt + Equity or D+E = $397.056 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 – .4645) x .0437 x ($175.466 /$397.056) + .0733 ($221.590 /$397.056)
.5355 x .0437 x .4419 + .0733 x .5581
.00103 + .0409
Based on the calculations above, we can conclude that Home Depot pays 5.12% on every dollar that it finances, or 5.12 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.05.12 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. WACC can be used as a hurdle rate against which to assess ROIC performance. It also plays a key role in economic value added (EVA) calculations.
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.