Financial Highlightsiv Essay
Weighted average cost of capital measures the current opportunity cost of capital- what is required return for each dollar lent to the company? To estimate Disney’s weighted average cost of capital (WACC) we need a cost of debt and a cost of equity. Cost of Debt Although the cost of debt can be found on the 10-K, since Disney relies on several different types of debt, we can make an estimate of the cost of debt by looking at its long-term debt rating (in 2007 they were rated A2 which is an upper medium grade rating). Disney’s debt rating corresponds to a debt cost of about 5%. The after-tax cost of debt equals 4.33% multiplied by 65%, or 2.8%.
Cost of Equity
Cost of equity is implicit, so there are several methods for calculating it, including the CAPM. The capital asset pricing model is a traditional method in which the expected return is a function the presumed risk of the stock as implied by the equity’s beta. A higher beta implies greater risk which, in turn, increases the expected return – and the expected return is the same as the cost of equity. (Expected return is simply the view from the investor’s perspective while cost
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If Disney’s beta is 1.17, and if we take the equity premium to be the same as the T-bonds risk free rate, then by using the CAPM formula, we add 5.8% (a 4.94% equity premium x 1.17 beta) to a risk-free rate of 2.0% for a total estimate for Disney’s cost of equity capital of 7.8%. The Weighted Average Cost of Capital To calculate the WACC we now need to multiply the cost of debt and equity by their respective proportions of invested capital, and add these results. On Disney’s 2009 balance sheet, long-term debt plus short-term debt plus other liabilities equals $29.383 billion. The market value of the equity (market capitalization) is $70.25 billion. Debt is therefore 29.5% of invested capital and equity is 70.5%. Now we multiply each type of cost of capital by its respective proportion of total capital and then we add the two weighted costs together to arrive at WACC.
Cost Share of Capital Weighted Cost 2.8% 29.5% = 0.83% 7.8% 70.5% = 5.48% WACC = 6.31% The WACC is an Investment Tool used by Securities analysts when valuing and selecting investments. WACC is sometimes used as the discount rate applied to future cash flows for deriving a business’s net present value. It represents the minimum rate of return at which a company produces value for its investors.
In Disney’s case, in 2009 it has a ROE of 9.8% and a WACC of 6.31%. This means that for every dollar the company invests into capital, the company is creating 3 cents of value. Under the equity valuation assumptions, the forecasted ROE is 12.65%, which would mean 6 cents per dollar invested. If on the contrary, the company’s return was less than WACC, this would indicate that investors should put their money elsewhere.
The average investor generally does not go through the trouble of calculating WACC yet it serves as a useful reality check for investors when they see it in brokerage analysts’ reports. DCF Free Cash Flow To Equity is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment and debt repayment. FCFE is often used by analysts in an attempt to determine the value of a company. This method of valuation gained popularity as the dividend discount model’s usefulness became increasingly questionable. It uses a Discounted Cash Flow based on forecasted Return on Equity. The WACC is also sometimes used as the discount rate to calculate the FCFE.
If the expected rate of return is higher than your required rate of return then stock is undervalued for you. Otherwise, if expected rate of return is lower than your required rate of return then stock is overvalued for you. In this Disney’s case the forecasted rate of return on equity for 2011 is 12.65%, and the expected rate of return implied by market price of common stock is 9.20%, this means that if we use market price as a basis, then the stock would be undervalued and is a good option to buy.
Discounted Abnormal Earnings & Discounted Abnormal Return on Equity The Discounted Return is a term used to describe the returns generated by a given security or portfolio over a period of time that is different from the expected rate of return. The expected rate of return is the estimated return based on an asset pricing model, using a long run historical average or multiple valuations.
Disney’s Book-To-Market Ratio, which is used to find the value of a company by comparing the book value of a firm to its market value, is 1.9 indicating that the stock is undervalued. An undervalued stock tends to trade at a lower price. Analysts will usually recommend an undervalued stock with a strong buy rating. Abnormal Returns are merely a summary of how the actual returns differ from the predicted return. In 2010, Disney has a 3.3% present value of abnormal return on common equity indicating that is higher than the expected rate of return. In Disney’s case, return forecast throughout the following years is positive.
Sustainable Earnings Sustainable Earnings Sustainable earnings are those that arise from normal business operations in a “normal” economic environment. A firm’s sustainable growth rate is defined as: Sustainable growth rate = ROE x (1 – Dividend payout ratio) This is a rate at which a firm can grow while keeping its profitability and financial policies unchanged. A firm’s return on equity and its dividend payout policy determine the pool of funds available for growth. Results for the Company’s SGR are as follows: 2006 2007 2008 2009 Sustainable Growth Rate 9.0% 13.2% 11.6% 7.9% By comparing to the Historic Values of Key financial Ratios Table (Source: Financial statement data for al publicly traded U.S. companies between 1987 and 2005), we can tell Disney’s trend is above average since the highest ratio was 8.6% in 2003.
Range of Assumptions Stock Option Compensation Expense
The Company awards stock options and restricted stock units to a broad-based group of management and creative personnel each year during the second quarter (the Annual Grant). The Company uses a binomial valuation model which takes into account variables such as volatility, dividend yield, and the risk-free interest rate. The binomial valuation model also considers the expected exercise multiple (the multiple of exercise price to grant price at which exercises are expected to occur on average) and the termination rate (the probability of a vested option being cancelled due to the termination of the option holder) in computing the value of the option. Accordingly, the Company believes that the binomial valuation model should produce a fair value that is representative of the value of an employee option.
Although the initial fair value of stock options is not adjusted after the grant date, changes in the Company’s assumptions may change the value of, and therefore the expense related to, future stock option grants. The assumptions that cause the greatest variation in fair value in the binomial valuation model are the expected volatility and expected exercise multiple. Increases or decreases in either the expected volatility or expected exercise multiple will cause the binomial option value to increase or decrease, respectively.
The volatility assumption considers both historical and implied volatility and may be impacted by the Company’s performance as well as changes in economic and market conditions. See Note 13 to the Consolidated Financial Statements for more detailed information. If the expected volatility of 47% used by the Company during 2009 was increased or decreased by five percentage points (i.e. to 52% or to 42%), the weighted average grant date fair value of our 2009 stock option grants would have increased by 9% or decreased by 7%, respectively.
The expected exercise multiple may be influenced by the Company’s future stock performance, stock price volatility, and employee turnover rates. If the exercise multiple assumption of 1.39 used by the Company during 2009 were increased to 1.6 or decreased to 1.2, the weighted average binomial value of our 2009 stock option grants would have increased by 7% or decreased by 8%, respectively.
Employee Compensation – Retirement Benefits Key assumptions used for the measurement of pension and postretirement medical plans at the beginning of fiscal 2009 were 7.80% for the discount rate, 7.50% for the rate of return on plan assets, and 5.00% for salary increases. Based on this measurement of plan assets and benefit obligations, pension and postretirement medical costs decreased to approximately $214 million for fiscal 2009 compared to $255 million for fiscal 2008. The decrease in pension and postretirement medical expense was primarily due to an increase in the discount rate used to measure the present value of plan obligations.
The Company remeasured plan assets and benefit obligations at October 3, 2009 in accordance with new guidance on accounting for retirement plans. Key assumptions for the measurement at October 3, 2009 were 5.75% for the discount rate, 7.75% for the rate of return on plan assets, and 4.50% for salary increases. Based on the measurement at October 3, 2009, the Company recorded an increase in unrecognized pension and postretirement medical expense, which totals $2.8 billion ($1.8 billion after-tax) as of October 3, 2009.
Pension and Other Benefit Programs Net periodic benefit cost is based on assumptions determined at the prior-year end measurement date. Actuarial assumptions, such as the discount rate, long-term rate of return on plan assets and the healthcare cost trend rate, have a significant effect on the amounts reported for net periodic benefit cost as well as the related benefit obligations.
Discount Rate The assumed discount rate for pension and postretirement medical plans reflects the market rates for high-quality corporate bonds currently available. The Company’s discount rate was determined by considering the average of pension yield curves constructed of a large population of high quality corporate bonds. The resulting discount rate reflects the matching of plan liability cash flows to the yield curves.