WACC for Woodside Petroleum
WACC for Woodside Petroleum is 4.74%. WACC is calculated using the following formula:
WACC = D/V (1-t)Kd + E/V Ke
where D is the market value of the debt.
E = equity market value
V denotes the firm's market value.
Kd = debt cost
Ke = equity cost of capital
T stands for tax rate.
The weighted average cost of capital is the minimum return that is predicted to increase shareholders' value in the current year (maximize their wealth). WACC is utilized as the discount rate applied to a firm's future cash flows and is thus valuable in company valuation. As a result, the minimum rate of return that will maximize the value of Woodside Petroleum's stockholders is 4.74%. Also, the company will use this rate as it is discounting its future cash flows, for example, when making capital budgeting decisions.
Explanation of Calculations and Judgments
The first step was calculating the cost of equity. To find the cost of equity, it was essential to find the beta of Woodside's stock which is deduced from the following regression model: Rj=α+bRm, where Rj= return of the Woodside's stock, Rm is the return of the market, the Y-intercept gives the alpha, and the slope is the beta. Daily stock returns were calculated from the daily adjusted close prices since January 2001 while the All Ordinaries Index represented the market. Data since January 1st, 2014 was collected and the daily returns calculated. The regression model was then run to give values of beta as 0.7124 (significant) and alpha as -0.0002 (not significant) indicated in worksheet labeled "Beta Est." After that, the cost of equity, Ke, was calculated using the formula Ke= α+βRm. From this calculation, Woodside's cost of equity is 5.78%.
The next step was calculating the cost of debt, Kd. Kd is given by the formula Kd= I/D, where I is the total interest expense while D is the total market value of debt (these two are from the balance sheet). In this case, Woodside's cost of debt for the year ended 2016 is 1.13%.
The final step was finding the weights for debt and equity. The total value of equity is given by the total number of shares outstanding multiplied by the adjusted share price. The total market value is the sum of the value of debt plus the value of equity, which is ASD 32,892 million (6873+26019). Therefore, the WACC is given by:
WACC= 6873/32892*0.0113(1-0.3)+26019/32892*0.7124= 4.74%
A major assumption made in this process is that there exists a linear relationship between the returns of Woodside Petroleum and the returns of the market, that is, the All Ordinaries. The linear relationship is what made it possible for a regression model to be applied. The second assumption is that despite the fact that the alpha estimate is not significant, the required rate of return on equity (cost of equity) will not be affected. Also, another assumption is that the market prices of both the all ordinaries index and Woodside's stock were not affected by market anomalies such as the weekend effect or the Monday effect. The meaning is that all the prices for the regular business days are available since January 2014.
Gearing Ratio
The gearing ratio is given by fixed interest bearing notes/shareholder's equity. For the year ended 2016, Woodside's gearing ratio was 0.3175 while for 2015 it was 0.2955. A gearing ratio of less than 0.5 is favorable because it indicates that the company does not depend on fixed interest debt to finance its operations and the conclusion is that Woodside Petroleum is financially sound and healthy. The debt to equity ratio for the year 2015 was 0.5804 while for the year 2015, it was 0.5866. Debt to equity ratio of 0.5804 shows that there are 0.5804 as many liabilities as there are assets in the company and this should be considered favorable because the company relies less on borrowed funds.
Capital Structure
Capital structure refers to the proportion or mix of equity and debt in a firm. For the case of Woodside in the year ended 2016, its capital structure consisted of 26.4% debt and 73.6% equity. Various capital structure theories have been proposed, and the first is the Modigliani and Miller capital structure irrelevance theory. They argued that in perfect markets, the capital structure is irrelevant, but the market value of any firm is determined by the risk and power of its underlying assets. Therefore, for the case of Woodside Petroleum, its value is independent of the proportions of debt and equity it uses to finance its investments. This means that even if the company uses 99% debt, the market value is the same as that of all equity firm. However, equity is more costly than debt and issuing more equity increases the cost of capital. In their third proposition, Modigliani and Miller asserted that increase in the use of debt increases the bankruptcy costs and therefore, there exists a tradeoff between equity and debt. The tradeoff introduces the concept of an optimal capital structure, the point at which the WACC is minimized, and the value of the firm is maximized. For Woodside Petroleum, it seems that its current capital structure of 26.4% debt is an optimal capital structure because its WACC is at a minimum.
The net income approach (NI) states that there exists a relationship between capital structure and firm value and as a result, capital structure affects the value of a company. The primary assumption is that investor's perceptions are not impacted by an increased amount of debt since it is cheaper than equity. The meaning is that if Woodside uses more debt, the WACC will continue to reduce because it is a cheaper source. The Net Operating Income theory (NOI) proposes that the value of Woodside is independent of its capital structure and an increase in the use of debt increases the financial risk to investors. Therefore, it does not matter the financing mix that Woodside uses because it has no effect on its value.
Recommendation to the Board
The capital structure of 26.74% debt and 73.6% equity is optimal because the WACC is at a minimum, 4.74% and the firm value is at a maximum. Also, at this point, the bankruptcy costs are low, and the investor's company will continue in operation for the foreseeable future. I can consider the use of more debt because debt capital is cheaper than equity because of the tax-deductibility of the interest. Therefore, the board can issue more debt without fearing whether the company will be able to meet the periodic interest payments.
Reflection
Market weights should be used in the calculation of WACC. WACC is a representation of the expectations that investors have about a company and should information that reflects the market expectations, that is, the market prices rather than historical book values. The market value of equity was calculated as the adjusted closing price as at 24th May 2017 while the number of shares is from the balance sheet. The book value of debt was used because Woodside Petroleum does not trade its debt. Using market values, the weight of equity is 0.7910 while using book values; the weight is 0.7590. There is a difference in the two weights: using book values and market values and I would use the market value which reflects the most recent market expectations.
I would use the ten-year bond as the risk-free rate. The requirements for a risk-free asset are no default risk and no reinvestment risk. The ten-year bond is used as a proxy to signal investor's confidence, and its default risk is low, and its yield is relatively stable. However, a thirty-year bond is exposed to maturity risk and has a higher chance of default compared to the ten-year bond. On the other hand, the five-year bond will be affected by the market expectations, and its prices fluctuate quite a lot.
The beta for Woodside Petroleum has been calculated as well as calculating the return on the market rather than using a spread between the risk-free rate and the market. The debt interest expense has been retrieved from the income statement as reported in the 2016 annual report.
