Components of Weighted Average Cost of Capital - Example

Number: Paper: Components of Weighted Average Cost of Capital (WACC) Weighted Average Cost of Capital or WACC is stated as financial metric, which is employed for measuring cost of capital of a company. It provides discounted rate of interest of a particular project (Penman, 2010). WACC of source of finance is calculated in order to evaluate whether it will return considerable benefit to the company. The source of finance of a company is basically debt and equity. The cost of equity and debt are calculated so as to understand the WACC of the company. WACC is measured by averaging the cost of the two sources of finance and offers appropriate weight age to both of them. The WACC for the healthcare services industry is provided in the table below (Damodaran, 2014): Industry Cost of equity Cost of debt Healthcare services 7.20% 6.04% The cost of equity and debt for the health care service industry is low with respect to other industries (Damodaran, 2014). WACC generally denotes the overall return generated by a business to satisfy the shareholders as well as the loan providers. Based on the WACC of a company, the shareholders judge its ability to offer them appropriate return. If the WACC is low, it is risky for the shareholders to invest in the stock as there is the chance that they may lose their invested amount due to market uncertainties (Pratt & Grabowski, 2014). Thus, the investments of the shareholders are subject to market risk. However, compared to other industries, WACC of healthcare industry is low (Damodaran, 2014), it implies the fact that the investors will be profitable if they invest in automobile and chemical industry instead of healthcare services industry. The calculation of WACC of UnitedHealth Group Inc (UNH) is provided below: Figure 1: WACC of UnitedHealth Group Inc (Source: Stock Analysis on Net, 2014) From the above table it is evident that fair value of equity of the company is high, which implies the fact that it finance its operation by issuing maximum number of shares to the shareholders. The company is dependent on the investments made by the shareholders and as a result it can be stated that UNH is aggressive in sourcing its finance. The shareholders bear the risk of losing the money by investing in the shares but at the time they hope for better return. However, UNH is observed to have provided higher ROE to the shareholders during the period 2013, which is higher than the industry average. Thus, it can be stated that the company has satisfied its customers with higher rates of return. The stock price of the company is $86.18 and the number of shares distributed is high. This denotes the fact that the shareholders rely on the performance of the company. The rate of return of equity is calculated by employing Capital Asset Pricing Model (CAPM). WACC is observed to be 10.46%, which is higher than the industry average. This indicates the fact that the company offers higher return to investors or shareholders in comparison to other companies in the same industry as the industry average is 6.77% (Damodaran, 2014). DCF Model-Optimistic, Pessimistic & Expected DAE Model-Optimistic, Pessimistic & Expected DAROE-Optimistic, Pessimistic & Expected Assessment of Solvency The solvency position of UNH can be evaluated by observing the debt to equity ratio over the 10 years. The following table highlights the solvency position of the company with respect to other companies and industry. Debt to Equity 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 UNH 1.60 1.33 1.32 1.54 1.69 1.50 1.44 1.40 1.59 1.55 HUM 1.71 1.78 2.32 2.20 1.93 1.45 1.33 1.20 1.26 1.23 AET 3.64 3.39 4.21 4.05 3.38 3.06 2.82 2.81 2.99 2.55 Industry 2.32 2.17 2.62 2.60 2.33 2.00 1.86 1.80 1.95 1.78 From the above table it can be depicted that UNH employs equity shares as the main source of finance. This is quite risky for the shareholders to invest as there is a chance for losing the invested amount. Hence, it can be stated that the solvency position of the company is weak if it is examined individually. However, if the solvency position is compared with other companies and industry it can be depicted that the company is in a stronger position with respect to others. The shareholders can take the risk of investing in UNH than other companies. Calculation of Altman’s Z Score Altman’s Z score is calculated in order to gauge the credit worthiness of a firm and whether it has a likelihood of bankruptcy. The score is based on fundamental ratios, which are evaluated by extracting financial data from the company annual report. Hence, the following formula is employed for calculating Altman’s Z score: Z-Score = 1.2W + 1.4X + 3.3Y + 0.6Z + 1.0E Where, W = Working Capital/Total Assets X= Retained Earnings/Total Assets Y = Earnings before Interest and Tax/Total Assets Z = Market Value of Equity/Total Liabilities E = Sales/Total Assets For a particular industry Z score below 1.8 denotes that the firm is probably heading towards bankruptcy. However, the score of 3 and above indicates the fact that firms will not encounter bankruptcy. The Z score value of few companies in the healthcare service industry is provided in the graph below: Figure 2: Z score of healthcare companies (2008-2012) (Source: SOFE, 2013) From the above graph, it can be deduced that UNH have maintained a safe score for the period 2008-2012 and as a result, it did not have encounter bankruptcy. In the healthcare industry, the score of 1.1 and below indicates to the risky position of the company as it can get bankrupted. However, in the same industry, a score above 2.6 is observed to be in a safe position. The Z score value of UNH ranges within1.83 to 2.11; hence, the company is in a safe position. The Z score value of the company has encountered huge fluctuation pre 2008 due to the market condition but it has gained its position after 2008 as its ability to generate higher returns increased. Estimation of Bond Rating based on ratios Based on the ratios that are employed for calculating Z score, bond rates are provided. Hence, bond rate is dependent on the performance of this ratios and how the ratios affects the company (Palepu and Healy, 2012). The companies whose ratios show stronger performance the bond rates are high in those cases. Reference List ( 2 references left) 1. Damodaran, A. (2014). Cost of Capital by Sector. Retrieved form http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm 2. Stock Analysis on Net. (2014). UnitedHealth Group Inc. (UNH). Retrieved from http://www.stock-analysis-on.net/NYSE/Company/UnitedHealth-Group-Inc/DCF/Present-Value-of-FCFF#WACC 3. SOFE. (2013). Published Articles. Retrieved from http://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=4&cad=rja&uact=8&ved=0CCwQFjAD&url=http%3A%2F%2Fwww.riskreg.com%2Farticles%2FTracy_Moenck_Quasnitschka_SOFE%2520Summer%25202013_Using%2520Z-Score.pdf&ei=UrkVVLmhEMa48gW6m4CgBA&usg=AFQjCNF1eL1pIE8BUh8qCTiNUNEfhG7A1A 4. Penman, S. (2010). Financial Statement Analysis and Security Valuation. New York: McGraw Hill. 5. Pratt, S. & Grabowski, R. (2014). Cost of Capital: Applications and Examples. New York: John Wiley & sons. 6. Palepu, K. and Healy, P. (2012). Business Analysis Valuation: Using Financial Statements. Connecticut: Cengage Learning. Read More