Introduction
Capital budgeting is a matter of heated discussion among scholars and practitioners. Indeed, the importance of the topic is difficult to overstate, as the capital investment decision-making process is crucial for the survival and long-term success of companies regardless of their size and industry (Kengatharan, 2016). One of the most frequently used methods for capital investment decision-making is the net present value (NPV) technique (Kengatharan, 2016). The methodology allows measuring the value of future money in today’s dollars using the idea of the cost of capital. The cost of capital differs depending on the capital component, which makes it difficult to estimate the cost of capital that should be used for calculations of NPV. The weighted average cost of capital (WACC) is most frequently used to calculate the cost of capital for estimating NPV. The present paper provides a discussion about the importance of WACC for capital budgeting and provides a detailed example of WACC calculations for American Telephone and Telegraph (AT&T).
Scope
WACC
WACC is a method of calculating the cost of capital by proportionally weighing every category of the source of capital (Hargrave, 2020). All sources of capital are included in the calculation of WACC to ensure the accuracy of estimations (Hargrave, 2020). The calculations require evaluating equity and its cost, debt and its cost, and the effective tax rate for the company. The present paper distinguishes between short-term and long-term debt, as they have different costs.
While the concept of WACC seems straightforward, there are certain limitations to the approach. In particular, the cost of equity and the cost of debt may be difficult to estimate, as there is no unique approach for addressing the matter. Thus, there may be significant differences in the results of WACC calculations depending on the method of evaluation. The present paper utilizes data acquired from Yahoo Finance, Moody’s, and Bonds Online to estimate various aspects of AT&T’s cost of capital.
AT&T Inc.
AT&T Inc. provides telecom services around the world. It has four segments, including Communications (wireless and wireline telecom), WarnerMedia (production, licensing, and distribution of films and TV programs), Latin America (video entertainment and audio programming services to residential customers), and Xandr (digital and video advertising) (Yahoo Finance, 2020). The company has been taking a leading position in the telecom industry in the US and abroad (Yahoo Finance, 2020). Even though the company’s revenues have been growing steadily, its net income decreased drastically in 2018 and 2019 (Yahoo Finance, 2020). In particular, even though the revenues increased by 12.9% between 2017 and 2019, it net income available to shareholders decreased by 53% during the same period (Yahoo Finance, 2020). This implies that the company needs to seek systematic change to address the identified problem. Systematic changes require significant investments, which need to be evaluated before implementation. Thus, the calculation of WACC will be critical for AT&T.
Investigation
The formula for WACC utilized in the present paper is the following:
Where:
- E-market value of the company’s equity;
- V = Short-Term Debt + Long-Term Debt +E – the total market value of the firm’s financing;
- Rsd – the cost of short-term debt;
- Rld – cost of long-term debt;
- Re – cost of equity;
- Tc – the effective tax rate for the company.
Some of the values for the formula can be found in AT&T’s financial statements provided by Yahoo Finance, while other components should be estimated using information from Moody’s and Bonds Online. First, the market value of the company’s equity is the market cap of the firm that can be found in the company’s profile provided by Yahoo Finance. On December 11, 2020, the company had a market cap equal to $218,697 million. The short- and long-term debts were found in the company’s balance sheet for 2019. The short-term debt was $5,711 million, and the long-term debt was $52,917 million. This implies that V in the formula is $277,325.
Estimation of the cost of debt may be tricky as it requires information about all sources of debt. According to Chen (2020), the effective interest rate on debt can be calculated by adding together all the interest rates on the existing debt and dividing them by the number of sources of debt. Such calculations require extensive information about AT&T’s debt structure, which cannot be acquired from open sources. Thus, the present paper distinguishes only between the short-term debt and the long-term rate. The cost of the short-term rate was calculated by adding the one-year yield margin and the six-month risk-free rate, while the cost of long-term debt was calculated by adding the ten-year yield margin and the ten-year risk-free rate. Since it was impossible to acquire the yield margins from Bonds Online free of charge, the yield margins were assumed at 115 basis points at one year and 210 basis points at ten years. The six-month risk-free rate was 0.09%, and the ten-year risk-free rate was 0.92%. Thus, the cost of short-term debt was estimated at 1.24% for short-term debt and 3.02% for long-term debt.
Capital Asset Pricing Model (CAPM) was used to estimate the cost of equity. The model is based on the idea that asset prices should not depend on all the risks (Rossi, 2016). Even though it has been used successfully for more than two decades, it is associated with an ongoing debate (Rossi, 2016). In particular, CAPM’s assumptions are believed to be unrealistic for various reasons (Rossi, 2016). According to the model, the cost of equity or the expected return of the investment can be calculated by adding a risk-free rate to the market risk premium multiplied by the company’s beta (Kenton, 2020). The market risk premium was estimated at 6%, and the risk-free rate was assumed at 0.98% (ten-year risk-free rate). The beta of the company was estimated at 0.67 (Yahoo Finance, 2020). Thus, the cost of equity was calculated in the following way:
After assuming the effective tax rate for the company at 35%, WACC can be calculated using the values provided above:
This implies that the cost of capital that can be used to calculate the present value of future cash flow for AT&T is 4.29%.
Conclusion
WACC is a useful tool that can be used for capital budgeting. While WACC relies upon a sound formula, the methodologies of valuation of different aspects of the formula are questionable. The investigation demonstrates that specialists are often forced to use estimations based on assumptions, as the required information may be unavailable. The calculations showed that the WACC of AT&T was 4.29%. This number can be used for assessing possible investments to address the company’s growing profitability problem.
References
Chen, A. (2020). Cost of debt. Investopedia. Web.
Hargrave, M. (2020). The weighted average cost of capital – WACC. Investopedia. Web.
Kengatharan, L. (2016). Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), 15-38.
Kenton, W. (2020). Capital asset pricing model (CAPM). Investopedia. Web.
Rossi, M. (2016). The capital asset pricing model: a critical literature review. Global Business and Economics Review, 18(5), 604-617.
Yahoo Finance. (2020). AT&T Inc. (T). Web.