Wacc Case
X. Weighted average cost of capital (WACC)
The valuation of Abercrombie & Fitch Co. is based discounting future cash flows and economic profit, for that the weighted average cost of capital is needed. The WACC is the opportunity cost when investing in Abercrombie & Fitch Co. opposed to other investments with a similar risk. Investors want their return to excess the WACC before it can be considered a good investment; since people in general are risk averse, they want compensation for taking on risk.
In its most simple form the weighted average cost of capital looks as the following equation (Koller p. 232, 2010):
Equation X – 1
WACC= DVkd1-Tm+EVke
D/V = target level of debt to enterprise value using market-based values
E/V = target level …show more content…
of equity to enterprise value using market-based values kd = cost of debt ke = cost of equity
Tm = company’s marginal income tax rate
As the equation shows the factors which affects the WACC is the capital structure of the company, the cost of debt with the impact of tax, and the cost of capital.
In rest of this section there will be steps, each estimating the different variables. Keep in mind that estimation is not a single correct answer, but using respected models as estimators will give a good unbiased suggestion with the goal of minimizing errors.
X.1 Estimating current capital structure
To estimate the WACC the capital structure is needed. To determine the current capital structure it is important that market-based value is used, and not the book value.
Some companies trade their debt public, if so the market value of the debt can be determined by using the TRACE pricing database and it would be the ideal method to use. Since in most cases book value reasonably approximates the current market value it will be observed in the Abercrombie & Fitch Co. Annual report and used to determine the capital structure (Koller p. 263, 2010).
To estimate the market value of the company, the number of outstanding shares is multiplied with the stock price at a given time Shares issued and repurchased by the company is not included in the calculation. The Outstanding shares it observed in the annual reports and the historical stock prices is found on the web …show more content…
(http://moneycentral.msn.com).
Table X- 1 Ratio: | 2006 | 2007 | 2008 | 2009 | 2010 | Average | D/V | 13,6% | 12,0% | 13,8% | 64,3% | 35,8% | 27,9% | E/V | 86,4% | 88,0% | 86,2% | 35,7% | 64,2% | 72,1% |
Source: Own calculation based on information from annual reports fiscals 2006-2010.
Table x -1 shows the Debt-to-value ratio and the Equity-to-value over the past five years and in the end the average. Three first three years states a very stable ratio, but in a mixture of more debt and an extreme decrease in the stock price do to the financial crisis, the ratio completely shifted. 2010 indicates that the ratio is moving towards the old target ratio. The average D/V over the five year period is 27,9%, it might seem unreasonable to use this ratio in the estimation of the WACC do to the fact that 3 out five years the D/V ratio was under 14%, but since according to Hirt and Block a business cycle is usually lasting around five years it would academically be the most correct thing to do (Hirt and Block p. 109, 2008).
X.2 Tax
The tax rate that will be used to estimate the WACC is 34,3 percent, which is the latest effective tax rate from the fiscal 2010 annual report. The statutory federal income tax rate in the United State is 35%, not far from the effective tax rate of 34,3% elected for further use. The effective tax rate has over last five years has been both higher and lower than the chosen one, but since it is effected foreign earnings, it would be most reasonable to chose the most current effective tax rate. X. 3 Estimating the cost of equity
Estimating the cost of equity is a very hard task, given that there is no perfect way to do it and no model has gained universal acceptance. The cost of equity is built in three factors; the risk-free rate, the market risk premium, and a company-specific risk adjustment. The most practical respected and commonly used model to estimate cost of capital is “capital assets pricing model”. Although CAPM has been under a lot of criticism, it has proven to be a solid theory over time and will remains the best model for estimating cost of capital when developing a WACC to use in a company Valuation (Koller p. 235, 2010). CAPM will therefore also be used in this case.
The big difference between the respected models is primarily how they define risk. One of the models that have earned some acceptance is the Fama-French three-factor model (Eugene, F.F. & Kenneth, R.F. 1992). Unlike CAPM which defines risk as a stock’s sensitivity to the stock market, Fama-French three factor model defines risk as a stock’s sensitivity to three portfolios; the stock market, a portfolio based on firm size, and a portfolio based on book-to-market ratio (Koller p. 235, 2010). The Fama-French three-factor model must assume to b a fairly new model since it was first introduces in the Journal of Finance in 1992. It is based on a solid empirical research it is yet to be proven reliable over time and still leaves a lot of unanswered questions that need to be investigated; for example how much data should be used. CAPM has some of the same questions, but is given the benefit of time.
The arbitrage pricing theory (APT) is a second alternative to CAPM. Unlike the two other models, it is rarely practice, but mainly a theoretical model. The main idea behind the model is that the premium of every factor affecting the cost of equity is multiplied with sensitivity of the factor. The expected return is then determined by cumulate them all plus the risk free rate. On paper this model seems extremely strong, but it does have its flaws; for example is not determined how many factors there is, what the factors represent or how to measure the factors (Koller p. 256, 2010). The arbitrage pricing theory is therefore not suitable as part of estimating the WACC for a company Valuation. X.3.1 Capital Asset Pricing Model (CAPM)
Based on what is discussed in previous section it is both accepted and noted that the CAPM model is not perfect, but is chosen to carry out the estimation of the cost of equity because of its widely acceptance and solid theory.
The equation for CAPM that will be used (Koller p. 235, 2010):
Equation X – 2
ERi= rf+βiERm-rf
E(Ri) = expected return of security i rf = risk-free rate βi = stock’s sensitivity
E(Rm) = expected return of the market
The risk-free rate and the market premium which is defined as E(Rm)- rf is the same for all companies that is represented in same indexes and located in same regions; for example the a Danish company might have a different risk-free rate and expected return on the stock market than a Japanese company would have. Beta is the only one that varies between companies; it represents the sensitivity, which means to what extent the stock covaries with the aggregate stock market (Koller p. 235, 2010).
X.3.1.1 – Estimating the risk-free rate
When estimating the risk –free rate the essence is to find an investment in the same country area that is risk-free, the most common thing to do is to look government default-free bonds. There might not be any “risk-free” long-term government bonds in the United States, but they have extremely low betas, therefore considered a sure investment and useable in the valuation process (Koller p. 236, 2010). Since Abercrombie & Fitch Co. is located in the United States and the cash flows are in US dollars, US treasury bonds will be used to estimate the risk-free rate; by having the same currency, inflation will be modeled consistently between cash flow and the discount rate. The term of the bond is also important, if short-term bonds are used in the valuation as the risk-free rate it will not recognize that a bondholder when the short-term bond matures can probably reinvest at a higher rate. According to Koller the most common bond to use when doing a U.S. corporate valuation is the 10-year zero-coupon government bonds also known as STRIPS (Koller p. 237, 2010).
Data has been collected for every month since February 1995 and the development on an annual basis is produced in appendix: WACC. As the graph will show the trend for the 10-year zero-coupon government bond has been declining over the past 15 years. Taking an average of all the months would not give a fair estimation of the risk-rate, as the average would not reflect what the rate is right now or to be in the future. Given that the fiscal year of 2010 ended on the 29th of January 2011, the best estimation will be the risk-free rate in February 2011 which is 3,7268 percent. Average of recent periods will not give a more accurate result.
For further calculation in the valuation 3,7268 percent will be used as the risk-free rate.
X.3.1.2 – Estimating the market risk premium
There is no single precise way to estimate the market risk premium and therefore it is one of most difficult and debated issues in finance. The risk premium is the same for all equities. It reveals by how much an investor can expect the market to outperform the risk-free rate. There is no model that have gained universal acceptance, but Koller refer to three methods which falls into three categories (Koller p. 238, 2010): * Estimating the future risk premium by measuring and extrapolating historical returns. * Using regression analysis to link current market variables, such as the aggregate dividend-to-price ratio, to project the expected market risk premium. * Using DCF valuation, along with estimates of return on investment and growth, to reverse engineer the market’s cost of capital.
Using historical data to estimate the future risk premium rely on the assumption that the historical returns equal what the future ones are going to be. Nobody knows what tomorrow brings and there is therefore no grantee that the future return is going to be the same as the past one.
Current financial ratios, such as the aggregate dividend-to-price ratio, the aggregate book-to-market ratio, or the aggregate ratio of earnings-to-price to estimate the expected return on stocks is well documented and has been tested by many authors (Koller p. 242, 2010). However the models do have some drawbacks; for example the aggregate dividend-to-price ratio can have a negative outcome which is inconsistent with risk-averse investors who demand a premium for holding volatile securities. Koller points out that no one has ever been able establish any long-term trends in market premiums (Koller p. 242, 2010).
For the purpose of estimating the CAPM a market premium is chosen from an external source, since the uncertainty around the models, own calculations would not expect to give a more accurate result. Koller suggest based on historical averages based on data for more than a 100 years that the market premium is between 4,5 and 5,5 percent(Koller p. 245, 2010). Even though there is no guarantee that U.S. stock market is going to perform as well the next 100 years as it did in the past 100, the best estimation at this point is still in the range of 4,5-5,5 percent.
For further calculation in the pursue of WACC, 5,5 percent will be use as the estimation of the market premium. It would be ideal to know the precise market premium in the valuation process, but since it is not possible it has been decided that the market premium will be in the high end of the suggested range. The WACC might be a bit higher, which might leads to the company might be undervalued; looking at an investor’s point of view is better than an overvaluation, since his investment might be more worth than first assumed instead of less. X.3.1.3 – Estimating the ANF’s sensitivity to the market
According to the Capital assets pricing model, a stock’s expected return is driven by beta (β) that is a measurement for how much the company stock and the entire market move together. Unlike the risk-free rate and the market premium, every company has their own beta. A company’s beta reflects not only the operating risk, but also the financial risk. Since it is not possible to observe beta anywhere calculations will have to be made to get a useable estimation. In every estimation judgment will have to be made, which means there is no exact answer.
To get beta, a regression will be conducted. The most common regression used to estimate a company’s beta is the market model (Koller p. 245, 2010): Ri=α+βRm+ε
Ri is the stock’s return and Rm is the market return. In the model the stock return is regressed against the market return, and in that way it is possible find out how sensitive the stock is to the market. All the calculation of the beta is in appendix: WACC.
Finding beta is not without its complication, good sense and judgment is required to make a reasonable result.
First of it has to be determined which index that is most suitable to regress the company against. This all depends where the company is located, since ANF is an American company the most obvious is the S&P 500 and MSCI world Index. It is very important not to use a small index such as a local market, since they can rely on few industries; in that case, the company’s sensitivity would be measured against other industries instead of the total market. For estimating Abercrombie & Fitch Co.’s beta, S&P 500 Index has been chosen, since according to Koller that is the most common used for U.S. stocks (Koller p. 249, 2010). Data used for estimating beta can determine the outcome. Using data from way back can include irrelevant data; for example if a company changes its strategy or capital structure, that would often lead to a change in risk and therefore also beta. For Regression Koller suggest that 5 years or 60 months with monthly observations on return should be used. More frequently return periods can lead to systematic biases and patterns. For the regression between ANF and S&P 500 60 months with monthly observations will be used. Even though the risk of systematic biases in errors are less than with weekly periods, there will still be tested for
it. Table X – 2 | Beta | S&P 500 | 1,7954557 |
Source: Own calculation
A beta of 1,795 is a pretty high sensitivity factor. This means that the stock will react heavily to movement on the total market. A beta in that league differently makes Abercrombie & Fitch Co. a risky stock. Some might argue that this seem way to high, but then again this probably is the best estimation of beta at this point using the market model.
Reasonable thinking tells when times are lean like under economic crisis, people have tendencies of substituting luxuries goods like expensive clothing with less expensive goods, visa versa when times are good.
A beta of 1,795 will be used for further calculation of WACC.
X.3.2 – Estimating the cost of debt
To estimate the cost of debt should be an easy thing to do, since a lot of companies trade their debt public. The direct way for investment-graded companies is to look at the yield to maturity of the company’s long-term, option-free bonds. Yield to maturity is only an approximation for the expected return, because yield is not the return, but the promised rate of return. It assumes all coupon payments are made on time and the debt is paid fully; the probability of default for companies with investment-grade debt rated BBB or better is very low. To estimate the cost of debt the direct way, the company has to trade long term debt and the debt has to be traded frequently, or ells the yield to maturity will be outdated.
Unfortunately Abercrombie & Fitch Co. does not trade their debt publicly and therefore do not have any issued bonds at this point, nor does the annual report reveal what the cost of debt is.
The next best way of determine the cost of debt is the indirect method; this is used on companies which debt is not traded that often and is a good substitute for the direct method. The debt is rated by agencies, and looking at the Koller’s “Yield Spread over U.S. Treasuries by bind rating” it can be decided what the yield to maturity is (Koller p. 259, 2010.(Bloomberg)). Since Abercrombie & Fitch Co. does not have any public traded debt the obvious thing to do is to look at the Peer group ratings. In the given Peer group there is only one company that have issued bonds at this point, Gap inc. Two companies can never be 100 percent comparable, there will always be some differences, and for that reason using Gap inc’s rating alone would not be sufficient. At this point the only option with the information at hand is to at look at the whole apparel industry in the United States, and locate the companies that have issued bonds. To get somewhat fair comparables, the companies need to have revenue above half a billion and need to be public traded to considered. Unfortunately there still are only few companies in the apparel business who issue bonds, but of the ones that are trading their debt, an average is made.
Table X – 3 10-year bond | Yield to maturity | Gap inc. Baa3/BBB- | 5,45% | Phillips van Heusen Baa3 | 3,80% | Phillips van Heusen BB | 5,45% | Jones apparel group Baa3 | 3,80% | Perry Ellis international inc B3/B+ | 5,45% | Average | 4,79% | (Source: own calculation based on numbers from oxa.marketwatch.com)
Table X – 3 shows the average 4,79% of all the yield to maturities from the different companies. To estimate the cost of debt the risk-free rate of 3,7268% which where determine earlier is added to the average yield to maturity 4,79 percent. The cost of debt is estimated to be 8,52% and will be used to estimate the weighted average cost of capital. Usually estimation of the beta and market premium more uncertain than the cost of debt, but in this case the cost of debt is just as uncertain as the two others. If Abercrombie and Fitch where issuing bonds the yield probably would not be 4,79%, but at this point the estimation cannot be more precise with the information used.
X.3.3 – Calculating the WACC
With all the information need, an estimation of weighted average cost of capital can be made. All the key numbers that has been estimated I this section is collected in table X – 4.
Table X – 4 Calculation of WACC | D/V | | | | 27,90% | E/V | | | | 72,10% | kd | | | | 8,52% | ke | | | | 13,60% | | rf | 3,73% | | | | βANF | 1,795 | | | | (E(Rm) - rf) | 5,50% | | | (1-Tm) | | | | 65,7% | | | | | | WACC | | | | 11,37% |
It is impossible to say if a WACC of 11,37 percent is a high or low estimate without known the average within the industry. Throughout the process there has been a great deal of estimation and judgment and the WACC should therefore not be seen as an accurate result, but more as an approximation. If 10 people estimated the WACC for the same company at the same time, probably none of them would get the same WACC, but it should be close.
--------------------------------------------
[ 1 ]. S&P 500 is a value-weighted index of large U.S. companies
[ 2 ]. MSCI World index is a value-weighted comprising large stocks from 23 developed countries
[ 3 ]. Grade system used by S&P to determine how risky the bond is. Other agencies use different but similar grading.
The valuation of Abercrombie & Fitch Co. is based discounting future cash flows and economic profit, for that the weighted average cost of capital is needed. The WACC is the opportunity cost when investing in Abercrombie & Fitch Co. opposed to other investments with a similar risk. Investors want their return to excess the WACC before it can be considered a good investment; since people in general are risk averse, they want compensation for taking on risk.
In its most simple form the weighted average cost of capital looks as the following equation (Koller p. 232, 2010):
Equation X – 1
WACC= DVkd1-Tm+EVke
D/V = target level of debt to enterprise value using market-based values
E/V = target level …show more content…
of equity to enterprise value using market-based values kd = cost of debt ke = cost of equity
Tm = company’s marginal income tax rate
As the equation shows the factors which affects the WACC is the capital structure of the company, the cost of debt with the impact of tax, and the cost of capital.
In rest of this section there will be steps, each estimating the different variables. Keep in mind that estimation is not a single correct answer, but using respected models as estimators will give a good unbiased suggestion with the goal of minimizing errors.
X.1 Estimating current capital structure
To estimate the WACC the capital structure is needed. To determine the current capital structure it is important that market-based value is used, and not the book value.
Some companies trade their debt public, if so the market value of the debt can be determined by using the TRACE pricing database and it would be the ideal method to use. Since in most cases book value reasonably approximates the current market value it will be observed in the Abercrombie & Fitch Co. Annual report and used to determine the capital structure (Koller p. 263, 2010).
To estimate the market value of the company, the number of outstanding shares is multiplied with the stock price at a given time Shares issued and repurchased by the company is not included in the calculation. The Outstanding shares it observed in the annual reports and the historical stock prices is found on the web …show more content…
(http://moneycentral.msn.com).
Table X- 1 Ratio: | 2006 | 2007 | 2008 | 2009 | 2010 | Average | D/V | 13,6% | 12,0% | 13,8% | 64,3% | 35,8% | 27,9% | E/V | 86,4% | 88,0% | 86,2% | 35,7% | 64,2% | 72,1% |
Source: Own calculation based on information from annual reports fiscals 2006-2010.
Table x -1 shows the Debt-to-value ratio and the Equity-to-value over the past five years and in the end the average. Three first three years states a very stable ratio, but in a mixture of more debt and an extreme decrease in the stock price do to the financial crisis, the ratio completely shifted. 2010 indicates that the ratio is moving towards the old target ratio. The average D/V over the five year period is 27,9%, it might seem unreasonable to use this ratio in the estimation of the WACC do to the fact that 3 out five years the D/V ratio was under 14%, but since according to Hirt and Block a business cycle is usually lasting around five years it would academically be the most correct thing to do (Hirt and Block p. 109, 2008).
X.2 Tax
The tax rate that will be used to estimate the WACC is 34,3 percent, which is the latest effective tax rate from the fiscal 2010 annual report. The statutory federal income tax rate in the United State is 35%, not far from the effective tax rate of 34,3% elected for further use. The effective tax rate has over last five years has been both higher and lower than the chosen one, but since it is effected foreign earnings, it would be most reasonable to chose the most current effective tax rate. X. 3 Estimating the cost of equity
Estimating the cost of equity is a very hard task, given that there is no perfect way to do it and no model has gained universal acceptance. The cost of equity is built in three factors; the risk-free rate, the market risk premium, and a company-specific risk adjustment. The most practical respected and commonly used model to estimate cost of capital is “capital assets pricing model”. Although CAPM has been under a lot of criticism, it has proven to be a solid theory over time and will remains the best model for estimating cost of capital when developing a WACC to use in a company Valuation (Koller p. 235, 2010). CAPM will therefore also be used in this case.
The big difference between the respected models is primarily how they define risk. One of the models that have earned some acceptance is the Fama-French three-factor model (Eugene, F.F. & Kenneth, R.F. 1992). Unlike CAPM which defines risk as a stock’s sensitivity to the stock market, Fama-French three factor model defines risk as a stock’s sensitivity to three portfolios; the stock market, a portfolio based on firm size, and a portfolio based on book-to-market ratio (Koller p. 235, 2010). The Fama-French three-factor model must assume to b a fairly new model since it was first introduces in the Journal of Finance in 1992. It is based on a solid empirical research it is yet to be proven reliable over time and still leaves a lot of unanswered questions that need to be investigated; for example how much data should be used. CAPM has some of the same questions, but is given the benefit of time.
The arbitrage pricing theory (APT) is a second alternative to CAPM. Unlike the two other models, it is rarely practice, but mainly a theoretical model. The main idea behind the model is that the premium of every factor affecting the cost of equity is multiplied with sensitivity of the factor. The expected return is then determined by cumulate them all plus the risk free rate. On paper this model seems extremely strong, but it does have its flaws; for example is not determined how many factors there is, what the factors represent or how to measure the factors (Koller p. 256, 2010). The arbitrage pricing theory is therefore not suitable as part of estimating the WACC for a company Valuation. X.3.1 Capital Asset Pricing Model (CAPM)
Based on what is discussed in previous section it is both accepted and noted that the CAPM model is not perfect, but is chosen to carry out the estimation of the cost of equity because of its widely acceptance and solid theory.
The equation for CAPM that will be used (Koller p. 235, 2010):
Equation X – 2
ERi= rf+βiERm-rf
E(Ri) = expected return of security i rf = risk-free rate βi = stock’s sensitivity
E(Rm) = expected return of the market
The risk-free rate and the market premium which is defined as E(Rm)- rf is the same for all companies that is represented in same indexes and located in same regions; for example the a Danish company might have a different risk-free rate and expected return on the stock market than a Japanese company would have. Beta is the only one that varies between companies; it represents the sensitivity, which means to what extent the stock covaries with the aggregate stock market (Koller p. 235, 2010).
X.3.1.1 – Estimating the risk-free rate
When estimating the risk –free rate the essence is to find an investment in the same country area that is risk-free, the most common thing to do is to look government default-free bonds. There might not be any “risk-free” long-term government bonds in the United States, but they have extremely low betas, therefore considered a sure investment and useable in the valuation process (Koller p. 236, 2010). Since Abercrombie & Fitch Co. is located in the United States and the cash flows are in US dollars, US treasury bonds will be used to estimate the risk-free rate; by having the same currency, inflation will be modeled consistently between cash flow and the discount rate. The term of the bond is also important, if short-term bonds are used in the valuation as the risk-free rate it will not recognize that a bondholder when the short-term bond matures can probably reinvest at a higher rate. According to Koller the most common bond to use when doing a U.S. corporate valuation is the 10-year zero-coupon government bonds also known as STRIPS (Koller p. 237, 2010).
Data has been collected for every month since February 1995 and the development on an annual basis is produced in appendix: WACC. As the graph will show the trend for the 10-year zero-coupon government bond has been declining over the past 15 years. Taking an average of all the months would not give a fair estimation of the risk-rate, as the average would not reflect what the rate is right now or to be in the future. Given that the fiscal year of 2010 ended on the 29th of January 2011, the best estimation will be the risk-free rate in February 2011 which is 3,7268 percent. Average of recent periods will not give a more accurate result.
For further calculation in the valuation 3,7268 percent will be used as the risk-free rate.
X.3.1.2 – Estimating the market risk premium
There is no single precise way to estimate the market risk premium and therefore it is one of most difficult and debated issues in finance. The risk premium is the same for all equities. It reveals by how much an investor can expect the market to outperform the risk-free rate. There is no model that have gained universal acceptance, but Koller refer to three methods which falls into three categories (Koller p. 238, 2010): * Estimating the future risk premium by measuring and extrapolating historical returns. * Using regression analysis to link current market variables, such as the aggregate dividend-to-price ratio, to project the expected market risk premium. * Using DCF valuation, along with estimates of return on investment and growth, to reverse engineer the market’s cost of capital.
Using historical data to estimate the future risk premium rely on the assumption that the historical returns equal what the future ones are going to be. Nobody knows what tomorrow brings and there is therefore no grantee that the future return is going to be the same as the past one.
Current financial ratios, such as the aggregate dividend-to-price ratio, the aggregate book-to-market ratio, or the aggregate ratio of earnings-to-price to estimate the expected return on stocks is well documented and has been tested by many authors (Koller p. 242, 2010). However the models do have some drawbacks; for example the aggregate dividend-to-price ratio can have a negative outcome which is inconsistent with risk-averse investors who demand a premium for holding volatile securities. Koller points out that no one has ever been able establish any long-term trends in market premiums (Koller p. 242, 2010).
For the purpose of estimating the CAPM a market premium is chosen from an external source, since the uncertainty around the models, own calculations would not expect to give a more accurate result. Koller suggest based on historical averages based on data for more than a 100 years that the market premium is between 4,5 and 5,5 percent(Koller p. 245, 2010). Even though there is no guarantee that U.S. stock market is going to perform as well the next 100 years as it did in the past 100, the best estimation at this point is still in the range of 4,5-5,5 percent.
For further calculation in the pursue of WACC, 5,5 percent will be use as the estimation of the market premium. It would be ideal to know the precise market premium in the valuation process, but since it is not possible it has been decided that the market premium will be in the high end of the suggested range. The WACC might be a bit higher, which might leads to the company might be undervalued; looking at an investor’s point of view is better than an overvaluation, since his investment might be more worth than first assumed instead of less. X.3.1.3 – Estimating the ANF’s sensitivity to the market
According to the Capital assets pricing model, a stock’s expected return is driven by beta (β) that is a measurement for how much the company stock and the entire market move together. Unlike the risk-free rate and the market premium, every company has their own beta. A company’s beta reflects not only the operating risk, but also the financial risk. Since it is not possible to observe beta anywhere calculations will have to be made to get a useable estimation. In every estimation judgment will have to be made, which means there is no exact answer.
To get beta, a regression will be conducted. The most common regression used to estimate a company’s beta is the market model (Koller p. 245, 2010): Ri=α+βRm+ε
Ri is the stock’s return and Rm is the market return. In the model the stock return is regressed against the market return, and in that way it is possible find out how sensitive the stock is to the market. All the calculation of the beta is in appendix: WACC.
Finding beta is not without its complication, good sense and judgment is required to make a reasonable result.
First of it has to be determined which index that is most suitable to regress the company against. This all depends where the company is located, since ANF is an American company the most obvious is the S&P 500 and MSCI world Index. It is very important not to use a small index such as a local market, since they can rely on few industries; in that case, the company’s sensitivity would be measured against other industries instead of the total market. For estimating Abercrombie & Fitch Co.’s beta, S&P 500 Index has been chosen, since according to Koller that is the most common used for U.S. stocks (Koller p. 249, 2010). Data used for estimating beta can determine the outcome. Using data from way back can include irrelevant data; for example if a company changes its strategy or capital structure, that would often lead to a change in risk and therefore also beta. For Regression Koller suggest that 5 years or 60 months with monthly observations on return should be used. More frequently return periods can lead to systematic biases and patterns. For the regression between ANF and S&P 500 60 months with monthly observations will be used. Even though the risk of systematic biases in errors are less than with weekly periods, there will still be tested for
it. Table X – 2 | Beta | S&P 500 | 1,7954557 |
Source: Own calculation
A beta of 1,795 is a pretty high sensitivity factor. This means that the stock will react heavily to movement on the total market. A beta in that league differently makes Abercrombie & Fitch Co. a risky stock. Some might argue that this seem way to high, but then again this probably is the best estimation of beta at this point using the market model.
Reasonable thinking tells when times are lean like under economic crisis, people have tendencies of substituting luxuries goods like expensive clothing with less expensive goods, visa versa when times are good.
A beta of 1,795 will be used for further calculation of WACC.
X.3.2 – Estimating the cost of debt
To estimate the cost of debt should be an easy thing to do, since a lot of companies trade their debt public. The direct way for investment-graded companies is to look at the yield to maturity of the company’s long-term, option-free bonds. Yield to maturity is only an approximation for the expected return, because yield is not the return, but the promised rate of return. It assumes all coupon payments are made on time and the debt is paid fully; the probability of default for companies with investment-grade debt rated BBB or better is very low. To estimate the cost of debt the direct way, the company has to trade long term debt and the debt has to be traded frequently, or ells the yield to maturity will be outdated.
Unfortunately Abercrombie & Fitch Co. does not trade their debt publicly and therefore do not have any issued bonds at this point, nor does the annual report reveal what the cost of debt is.
The next best way of determine the cost of debt is the indirect method; this is used on companies which debt is not traded that often and is a good substitute for the direct method. The debt is rated by agencies, and looking at the Koller’s “Yield Spread over U.S. Treasuries by bind rating” it can be decided what the yield to maturity is (Koller p. 259, 2010.(Bloomberg)). Since Abercrombie & Fitch Co. does not have any public traded debt the obvious thing to do is to look at the Peer group ratings. In the given Peer group there is only one company that have issued bonds at this point, Gap inc. Two companies can never be 100 percent comparable, there will always be some differences, and for that reason using Gap inc’s rating alone would not be sufficient. At this point the only option with the information at hand is to at look at the whole apparel industry in the United States, and locate the companies that have issued bonds. To get somewhat fair comparables, the companies need to have revenue above half a billion and need to be public traded to considered. Unfortunately there still are only few companies in the apparel business who issue bonds, but of the ones that are trading their debt, an average is made.
Table X – 3 10-year bond | Yield to maturity | Gap inc. Baa3/BBB- | 5,45% | Phillips van Heusen Baa3 | 3,80% | Phillips van Heusen BB | 5,45% | Jones apparel group Baa3 | 3,80% | Perry Ellis international inc B3/B+ | 5,45% | Average | 4,79% | (Source: own calculation based on numbers from oxa.marketwatch.com)
Table X – 3 shows the average 4,79% of all the yield to maturities from the different companies. To estimate the cost of debt the risk-free rate of 3,7268% which where determine earlier is added to the average yield to maturity 4,79 percent. The cost of debt is estimated to be 8,52% and will be used to estimate the weighted average cost of capital. Usually estimation of the beta and market premium more uncertain than the cost of debt, but in this case the cost of debt is just as uncertain as the two others. If Abercrombie and Fitch where issuing bonds the yield probably would not be 4,79%, but at this point the estimation cannot be more precise with the information used.
X.3.3 – Calculating the WACC
With all the information need, an estimation of weighted average cost of capital can be made. All the key numbers that has been estimated I this section is collected in table X – 4.
Table X – 4 Calculation of WACC | D/V | | | | 27,90% | E/V | | | | 72,10% | kd | | | | 8,52% | ke | | | | 13,60% | | rf | 3,73% | | | | βANF | 1,795 | | | | (E(Rm) - rf) | 5,50% | | | (1-Tm) | | | | 65,7% | | | | | | WACC | | | | 11,37% |
It is impossible to say if a WACC of 11,37 percent is a high or low estimate without known the average within the industry. Throughout the process there has been a great deal of estimation and judgment and the WACC should therefore not be seen as an accurate result, but more as an approximation. If 10 people estimated the WACC for the same company at the same time, probably none of them would get the same WACC, but it should be close.
--------------------------------------------
[ 1 ]. S&P 500 is a value-weighted index of large U.S. companies
[ 2 ]. MSCI World index is a value-weighted comprising large stocks from 23 developed countries
[ 3 ]. Grade system used by S&P to determine how risky the bond is. Other agencies use different but similar grading.