You will be able to estimate a cost of equity and a weighted average cost of capital for your company.
Two analysts value the same company with the same cash flow forecast. One uses a discount rate of 8%, the other 10%. Lesson 8.1 showed what that does: for Larkspur, the gap is about S$2.11 against S$1.56 a share. Neither analyst is lying, but only one can defend every input with a source and a date. This lesson builds a discount rate you can defend, and shows where the judgment calls sit so you can make them openly.
All rates and figures here are made up for the example. Look up current values yourself and write down the date.
Shareholders take the most risk, so they demand the highest return. The standard way to estimate it is the capital asset pricing model: the cost of equity equals a risk-free rate plus beta times an equity risk premium.
The risk-free rate is the return on a government bond in the same currency as your cash flows. Larkspur's cash flows are in Singapore dollars, so use a Singapore Government Securities yield, usually the ten-year bond, which matches the long life of the cash flows. MAS publishes SGS yields on its website. Marcus used a made-up 3%.
Beta measures how much the stock moves with the market, the figure you calculated in lesson 2.4, Beta, correlation and why diversification shrinks in a crisis. For a thinly traded small company, a beta calculated from its own share price is unreliable, because the price doesn't update often enough to show its real sensitivity. Analysts often take the average beta of a group of similar companies instead. Marcus used a made-up 1.25, reflecting a cyclical supplier that moves more than the market.
The equity risk premium is the extra return investors demand for holding shares rather than government bonds. Nobody can observe it directly. Estimates come from history or from current prices and vary between sources. Aswath Damodaran of New York University publishes estimates on his website that many analysts refer to. Marcus used a made-up 5.5%.
Cost of equity: 3% plus 1.25 times 5.5%, which is about 9.9%.
The cost of debt is what the company would pay to borrow today, not the rate on loans it took out years ago. For a company with listed bonds, the yield on those bonds is the best guide. For one with only bank loans, like Larkspur, use the current rate on its floating loans from the borrowings note, or the risk-free rate plus a margin typical for similar borrowers.
Interest is usually deductible for tax, so the cost to the company is lower than the rate it pays. Multiply by one minus the tax rate. Marcus used a made-up pre-tax rate of 5% and Larkspur's assumed 17% tax rate: 5% times 0.83 is about 4.15% after tax.
The weighted average cost of capital, or WACC, blends the two by how much of each the company uses.
Use market values, not the book values on the balance sheet. Investors put money in or take it out at today's prices, so today's prices are what their required return applies to. For equity, that's the share price times the number of shares. For debt, book value is usually close enough unless the company is in trouble.
Larkspur's equity is worth 300 million shares at S$1.60: S$480 million. Its debt is S$60 million of bank loans plus S$20 million of lease liabilities, S$80 million in all, consistent with treating leases as debt in lesson 8.1, What a DCF says: value as cash flows discounted for time and risk. Total capital: S$560 million. Equity is about 85.7% of it and debt about 14.3%.
WACC is 85.7% times 9.9%, plus 14.3% times 4.15%: about 9.1%. Marcus used 9% in his model and let the sensitivity table in lesson 8.6 cover the range around it.
Had he used book values, with equity at its balance sheet figure of S$285 million, debt would have looked like a larger share and WACC would have come out at about 8.6%, which would have lifted his value per share. It's a common error and it always flatters.
Every input above changes over time. SGS yields move daily. Betas drift. Estimates of the equity risk premium are revised. A WACC without dates is impossible to check or update.
So next to each input in your Inputs tab, write three things: the value, the source and the date. "Risk-free rate: ten-year SGS yield, MAS website, checked on a given date." "Beta: average of five peers, five years of monthly returns, from a named data source, on a given date."
Two habits help. Use a long-term government yield even when short rates are higher or lower, because a DCF values decades of cash. And resist adding extra premiums for every worry. If Larkspur's customer concentration bothers you, put that risk in the cash flow scenarios in lesson 8.6, where you can see it, rather than adding two points to the discount rate, where it hides.
Now calculate a WACC for your own company, with the source and date of every input written beside it.
Calculate a WACC for your company, writing the source and date of every input beside it.
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