Weighted average cost of capital of Honeywell International Inc

WACC Project

1. Introduction

In this report, an attempt is made to ascertain the weighted average cost of capital of Honeywell International Inc. The calculation of weighted average cost of capital is made by collecting data from multiple sources and making judgments that are subjective. The main purpose of the report is make financial analysis from the diversified data that are publicly available. The aim of this report is to calculate the weighted average cost of capital by ascertaining the cost of each component of the capital structure.

2. Background of the company

The Honeywell International Inc. is engaged in the invention and manufacturing of technological product that address critical challenges faced all around the globe like safety, energy and security. The company uses a unique blend of combining the physical product with the software’s in order to improve the building, homes, factories and utilities (Frank & Shen, 2016). This has enabled to develop a safer, comfortable and productive world. The solutions provided by the company has enabled to improve the quality of life all around the world. Further, the solutions provided by the company has enabled to create new markets and industries. The company nearly earns half of its revenue from the energy efficient products. The company is engaged in promoting good and safety living by supporting clean water and air. The aim of the company is to provide better quality of life and sustainable environment for future generation (Kaplan, R. S., & Atkinson, 2015).

The company has dedicated workforce of engineers that are focused on developing software’s. This software’s are compatible with the Capability Maturity Model Integration level 5 therefore; this enables the company for continuous improvement and innovation of the product (Baker & Wurgler, 2015).

This company is a Fortune 100 companies that have provided its shareholders 118% return for the last 5 years. In 2015, the company had an approximate sales of $40 billion. The financial record of the company shows that its performance has been strong over the years. The company has a unique feature that it develops a financial target that it wishes to achieve. This feature has separated the company from its peers (Ondraczek et al., 2015).

3. Brief description and calculation

3.1 Cost of Equity

The cost of Equity is the rate of return that the shareholders expect from their investment. There are two methods for determining the cost of equity the Capital Assets Pricing Model (CAPM), Dividend Growth Model and own bond yield plus judgment risk premium method.

3.1.1 Capital Assets Pricing Model

The most commonly used method for determining the cost of equity is the Capital Assets Pricing model. This model determines the association between return expected from an asset and the systematic risks (Gambacorta & Shin, 2016). The formula that is applied for calculating the CAPM is given in the calculation below:

CAPM: R_E = R_RF + (R_M – R_RF)b

= R_RF + (RP_M)b.

R_E refers to the cost of equity;

R_RF refers to the risk free return;

R_M refers the expected return form the market;

B refers to Beta;

Beta from regression and analysts

The beta refers to the relationship between the share price of the company and the market as a whole. If the beta of the company is one then it means that the movement of the company is in line with the market. The beat can be calculated using the regression model. The regression analysis is conducted by comparing the historical market price of the share with the S&P index. The beta that is calculated using regression analysis is 0.071168 and it is provided in Annexure 1. The beta of the stock that is provided in the yahoo finance is 0.951065. The beta of the stock is 0.94 for the Honeywell International as per Google finance (Kisin & Manela, 2016).

Beta selected for CAPM

The above discussion shows that there are three beta of the company. The beta of the company on regression is different from the beta provided by the yahoo and Google finance. Therefore, for the purpose of calculation of cost of equity based on the CAPM model the beta that should be used is the average of three betas (0.071168+0.951065+0.94)/3 is 0.654078.

Risk free Return

The risk free return is the amount of return that can be obtained from investment in securities that can be considered as risk free. The interest rate of U.S Treasury bill is regarded as the risk free rate of return for the purpose of calculation (Core et al., 2015). Therefore, the risk free rate of return that is taken for the purpose of calculation is 2.244%. The details of the calculation is provided in Annexure 2.

Market rate of return

The market rate of return is the return that the investor expects for taking the risk of investing in the stock market. The difference between the market rate of return and the risk free rate of return is known as the market risk premium. This premium return is received by an investor for taking the risk of investing in the stock market. The market rate of return can be calculated by averaging the rate of return that can be obtained from investing in the stock market (Brotherson et al., 2015). In this case, the market rate of return is calculated by fining the arithmetic mean of S&P 500 provided in the Annexure 1. The calculation is shown in the annexure the annual market rate of return is 11%.

Calculation of CAPM

The above discussion shows that all the important components of the CAPM has calculated. The calculation is provided below:

R_RF refers to the risk free return is 2.244%;

R_M refers the expected return form the market is 11%;

B refers to Beta is 0.654078

R_E = R_RF + (R_M – R_RF) X b

= 2.244% + (11%-2.244%) X 0.654078

= 9.42%

3.1.2 Dividend Growth Model

The traditional method of calculating the cost of equity is the dividend growth model. The formula is provided below:

R_E = &lbrace [D₀* (1+g)] /P₀ &rbrace + g

R_E refers to the cost of equity;

D₀ is the current year’s dividend;

G is the growth rate;

P₀ is the current stock price_;

In this method, it is important to calculate the dividend growth rate. The calculation is given below:

Table 1: Dividend growth rate

(Source: created by author)

The above calculation shows that the dividend growth rate to be taken for the purpose of calculation is 12%. The current year’s dividend is $2.15. The current market price of the share is $124.56. The calculation for cost of equity is given below:

R_E = &lbrace [D₀* (1+g)] /P₀ &rbrace + g

= ((2.15 X (1+12%)/124.56) + 12%

= 13.93%.

Based on the above calculation the cost of equity is calculated to be 13.93% by using the dividend growth model.

3.1.3 Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method

This is another method that can be used for calculating the cost of equity. In this method the cost of equity is calculated by adding the equity risk premium with the long term yield of the bond. If the cost of equity is widely different under CAPM method and dividend growth method then it acts as an important check (Allcott & Wozny, 2014). The market risk premium for the stock is the difference between the return from the stock and risk free return. The discussion earlier have shown that the risk free return for marketable securities is 2.04% and the market return is 11%. Therefore, it can be said that the risk premium is 9% (approx.). The cost of debt calculated earlier is 14%. The formula for calculation is given below:

R_E = R_D + Judgmental risk premium

= 14% + 9%

=23%

Therefore, based on the above calculation it can be said that the cost of equity under this method is 23%.

3.1.4 Selecting the cost of equity

The discussion above shows that there are three methods that have been applied for calculating the cost of equity. The cost of equity using the CAPM method is 8%, and dividend discount method is 14%. The cost of equity under this two method differs widely so Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method is used for verifying the cost of equity (Fang et al., 2015). The cost of equity in this method is 23%. Therefore, based on the above discussion the cost of equity that is taken for calculating the cost of capital is the average of the three and it comes to 15.5% as it is between the two extremes.

3.2 Cost of Preferred Stock

The cost of preferred stock is the rate of return that is required by the preference shareholders. It is calculated by dividing the annual dividend with the current market price of the share (Robinson et al., 2016). The formula is given below:

R_PF = Dividend/P₀

In this case, the company does not have any preferred stock. Therefore the cost of preferred is not calculated.

3.3 Cost of Debt

The cost of debt is referred to as the effective rate of interest that the company pays for using the debt capital. The company uses various bonds, debts and loans so the calculation of the cost of debt is essential because it gives an idea of the cost incurred by the company for overall debt financing (DiMasi et al., 2016). The cost of debt incurred by the company is calculated by dividing the total interest paid by the company with the total debt. The calculation is provided in the Annexure 3 and it can be seen from the calculation that the cost of debt is 3%. The after tax cost of debt is calculated by multiplying the cost of debt with the marginal tax rate.

The cost of debt is calculated using the market value method. In this method the market value of each bond is calculated. Then the yield to maturity of each bond is multiplied with the weightage of market of bond for calculating the cost of debt (Li et al., 2013). The calculation showing the cost of debt is provided in Annexure 3. Therefore, based on the calculation it can be said that the cost of debt based on the weighted market value of debt is 14%. The 14% cost of debt will be used for calculating the weighted average cost of capital.

3.4 Market Value of Debt

The market value of debt is calculated by multiplying the price with the number of bonds. The calculation of market value of debt is provided in Annexure 3. The calculation shows that the total market value of the debt as the $13705.48 million. In addition to this any other long term leases from the balance sheet should be added with bonds to find the total market value of debt (Jenter & Kanaan, 2015). In this case, the company does not have any long-term lease in the balance sheet so the market value of the debt will be the same as provided in the Annexure 3.

3.5 Market Value of Equity

The market price of equity is calculated by multiplying the current market price of shares with the number of stock outstanding (Acharya et al., 2017). The current market price of shares is $124.56. The total number of shares outstanding as at 2015 year ending is 770.4 million. Therefore the total market value of equity is (124.56 X 770.4) $95961.02 million.

3.6 Market Value of Preferred Stock

The company does not have any preferred stock. Therefore, calculation of market value pf preference share is not required in this case.

3.7 Value of Firm

The total value of the firm is determined by calculating the Enterprise value. The enterprise value is an alternative method for determining to equity market capitalization for calculating the market value of equity (Hann et al., 2013). The formula that is used for calculating the Enterprise value is given below:

Enterprise Value= market value of equity+ market value of preferred stock + market value of debt + minority interest – cash and investments.

In this case, the calculation showing the enterprise value of the company is provided below:

Table 2: Enterprise Value

(Source: created by author)

The calculation above shows the Enterprise value of the firm and it comes to $104346.51 million.

3.8 Firm’s Tax Rate

The tax rate of the business can be calculated by referring to the annual report of the company. The tax rate is calculated by dividing the tax paid with the earnings before interest and taxes. The calculation is provided below:

Table 3: Tax Rate

(Source: created by author)

The calculation above shows that the tax are for the company is 26%.

3.9 Weight for Equity

In order to calculate the WACC the weightage that is used is the market value of equity. In this case, the market value of equity is $95961.02.

3.10 Weight for Preferred Stock

In this case, the company does not have any preference shares. Therefore, no weightage is calculated.

3.11 Weight for Debt

The market value of debt is used as the weightage for calculating the weighted average cost of capital. The market value of debt is $13705.48.

3.12 WACC (Weighted Average Cost of Capital)

The weighted average cost of capital is the minimum after tax return that the company should earn for all its stakeholders. This calculated after ascertaining each component of the capital structure of the company (Lai et al., 2014). The WACC is an important tool for determining whether the company is increasing wealth or is just covering the cost. The formula for calculating the WACC is given below:

WACC = [(w_E) x R_E] + [(w_PF) x R_PF] + [(w_D) x R_D x (1- T_C)]

Where:

Weights

(w_E) = % of common equity in capital structure

(w_PF) = % of preferred stock in capital structure

(w_D) = % of debt in capital structure

Component costs

R_E = firm’s cost of equity

R_PF = firm’s cost of preferred stock

R_D = firm’s cost of debt

T_C = firm’s corporate tax rate

The calculation of the WACC of the Honeywell International Inc. is provided in the Annexure 4. Therefore, it can be said that the WACC of the company is 14.17%.

4. Assumptions

The calculation of WACC involves making certain reasonable assumptions. The significant assumptions that have been made have been provided below:

• It is assumed that the return received from the treasury bond is regarded as the risk free rate of return.
• It is assumed that the market rate of return is the return of S&P index.
• It is assumed that the future dividends will grow at the historical rates.
• It is assumed that the cost of equity is the average of cost that is determined from the three methods.

5. Conclusion

The above discussion shows the calculation of the weighted average cost of capital. Based on the above discussion it can be said that the process of ascertaining the cost of capital involves making some assumptions. In this case, the weighted average cost of capital of the company is calculated to be 14.17%.

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