Using the Case Study Notes and the accompanying spreadsheet, calculate the WACC of each Microsoft segment comparable. Describe the primary WACC drivers that explain the differences between the WACC of Microsoft and its comparables.
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Weighted Average Cost of Capital Case Calculations Cost of Capital Components Capital Structure Components WACC Expected Return of Risk Free Pre-Tax Short-Term Long-Term Beta Market Rate Tax Rate Debt Cost Bond Rating Equity Debt Debt Total Capital Target Moody's Microsoft Q1 1,08 9,95% 3,06% 51,39% 2,525% AAA 878.361,6 8.072 79.856 966.289,6 9,66% Q2 1,07 10,71% 2,68% 15,99% 2,525% AAA 780.362,3 5.182 80.301 865.845,3 10,37% Peers IBM Q1 1,02 9,64% 2,41% 28,52% 2,992% A1 125.105,3 11.563 37.142 173.810,3 7,64% Q2 1,05 9,35% 2,01% 27,67% 2,653% A1 122.162,2 15.913 56.126 194.201,2 6,82% Oracle Q1 1,23 9,93% 2,86% 60,00% 3,600% A3 185.138,4 3.743 54.386 243.267,4 9,14% Q2 1,13 10, 18% 2,99% 60,00% 3,600% A3 177.096,3 6.477 51.561 235.134,3 8,73%Case Study Notes Companies within the same sector typically share similar capital | RISK FREE RATE structures and costs of capital. For example, most power utili- The risk free rate is the U.S. government bond. A U.S. bond's ties are engaged in fundamentally the same business; genera- yield is considered risk free because the U.S. has not and is not tion, transmitting, and distributing electric power. The utility expected to default. business is highly dependent upon expensive fixed-asset invest- ments (i.e., power plants) which are often financed with debt. TAX RATE Consequently, analysts expect companies within the same sec- The company's tax rate impacts the after tax cost of debt but tor or industry to have similar betas, capital structures, bond has no bearing on either the cost of preferred equity or com- ratings, and WACCs. mon equity. The higher a company's tax rate the lower the after Disney is a diversified entertainment company. Its diversi- tax cost of debt. Consequently, as a source of capital, debt is a fication exists because its revenues come from four different, tax shield. but related, business segments-parks and resorts, studio enter- tainment, broadcasting and media, and consumer products. PRE-TAX COST OF DEBT Since there is no other enterprise quite like Disney, we exam- The pre-tax cost of debt can be determined by calculating the ine the WACCs of companies that operate within one or more yield to maturity on the company's bonds. A bond's yield to of its segments. maturity can be influenced by many factors including inflation, Beta credit quality, macroeconomic fundamentals, and how the com- The beta of a stock is a representation of how the stock moves pany's bonds are structured. with the broader equity market. Disney has a beta of 0.96 which implies that when the broad equity market goes up or down by one percent, Disney's stock will rise or fall by 0.96 percent. Low beta stocks, between 0.5 and 0.8, tend to be defensive. They do not rise much when the market rises, but they also do not fall significantly when the market falls. Disney's beta indi- cates a closer relationship to the market than any of its peers used in this case. Betas of Companies Comparable to Disney Segments All Data as of July 31 2019 1.60 1.46 1.40 1.21 1.20 1.10 0.96 1.00 0.89 0.86 0.92 0.77 0.81 0.80 0.80 0.40 0.20 0.00 Disney Six Flags Cedar Fair Lion's Gate Viacom Netflix Sally Beauty Game Stop EXPECTED RETURN OF THE MARKET The expected return of the market is a fairly general observa- tion. In reality, no one knows by what degree the stock mar- ket will rise or fall over the next year. Nevertheless, in order to assess an individual stock we must have a view on where the broader market is heading. The expected return of the market is the same for every stock
