Cost of Capital, RD
A high credit rating indicates a lower cost of capital for most industries and organizations. Volkswagen had a rating of BBB+ with a positive outlook in May 2021 (Fitch Ratings, 2021a). The company’s rating is based on three critical components, including financial profile, corporate governance, and business characteristics. The BBB+ rating is Volkswagen’s long-term issuer default rating (IDR), which reflects the business’s robust and resilient fiscal performance throughout the diesel crisis and the COVID pandemic (Fitch Ratings, 2021b). It also points to solid business features that are shown through healthy liquidity and monetary flexibility. The positive outlook is an indicator of more manageable and improved corporate governance at Volkswagen. While the company has a complex shareholding arrangement and its board independence is limited, analysts foresaw a higher level of manageability.
A mix of other factors influenced Volkswagen’s credit rating in 2020. These issues include a decline in earnings from 6.7% in 2019 to 4.3% in 2020 and the sustenance of a positive free cash flow (FCF) of 2.3% in 2020 (Fitch Ratings, 2021b).
It also had a low ESG Relevance score of four for both emissions and air quality and governance structure (Fitch Ratings, 2021b). The company has invested in the car battery segment to strengthen its supply chain but failed to meet its emission targets for 2020. Since Volkswagen’s rating is not one of the highest in the corporate sector, the cost of debt should be increased. According to the Fidelity Fixed Income data, corporates with the BBB credit rating have a 4.76% yield or return on a 30year bond (Fidelity, 2021). Notably, this value was the highest among all the corporate returns listed on the web page. Therefore, Volkswagen’s approximate cost of debt capital, RD = 4.76%.
Cost of Equity, RE
The cost of equity calculation requires three values: beta, risk-free rate, and equity risk premium. In essence, the cost of equity refers to the amount spent in maintaining a fair share price to keep investors’ confidence in the company. The return on shareholders’ investment is a cost to the organization and is necessary to sustain a healthy share price and valuation. According to Infront Analytics (2021), the two-year beta of Volkswagen’s stock is 1.19, which signifies higher volatility than the market. Therefore when the stock market shifts upward, Volkswagen’s shares will be even higher and similarly for a downward shift.
The most desired beta is a value below the market figure of 1.0. The three-month Treasury bill return, which will be used as a risk-free rate, is 0.34% (Fidelity, 2021). A risk-free rate of return is often theoretical as it describes the yield expected on investment with zero risks. Since all investments carry some level of risk, this rate does not exist in the practical market. The US three-month Treasury bill is often used as the risk-free return rate because investors never expect the government to default (Advani, 2018). However, it is only applicable to investments made in US dollar currency.
When investors choose investments with risk instead of risk-free ones, they get excess returns called the equity risk premium. Therefore, it is compensation or reward given to investors for investing in equity rather than risk-free securities (Advani, 2018). When the stock involves a higher risk, the expected equity premium is also higher. For example, if a company stock has a 13% return and government bonds yield 7%, the equity risk premium becomes 13% – 7% = 6%. The equity risk premium used in this project was modeled to be approximately 5.55% in 2019 (Moschella, 2019). In calculating the cost of equity, beta is multiplied by the equity premium, and the product is added to the risk-free rate.
= 0.34% + 1.19 *(5.55%) = 0.34 + 6.6045
RE = 6.94%
Equity vs. Debt Capital, E/V and D/V
Companies use capital to fund their operations and fuel growth. Most organizations combine a variety of capital forms, mainly debt and equity. Capital is often listed as assets, equity as shareholders’ equity, and debt as liabilities on the balance sheet. Optimal capital structure is achieved when a business uses an ideal balance of equity and debt (Advani, 2018). Fast-growing companies have a high leverage ratio, which is indicated by having more debt than equity. Organizations using more equity than debt to fund their activities have a lower ratio, are conservative, and report low growth (Advani, 2018). Nevertheless, industry specifics determine the capital structure, with labor-intensive companies using more equity while capital-intensive ones use more debt.
Volkswagen’s quarterly data was used to calculate the total value of liabilities and shareholders’ equity to ensure the latest information was obtained. By the end of June 2021, Volkswagen’s total liabilities were equal to $ 377,105,000, while shareholders’ equity was valued at $ 140,014,000 (Yahoo Finance, 2021). Therefore, the total value was 377,105,000 + 140,014,000 = $ 517,119,000. Each proportion is divided by the total value to obtain the E/V and D/V figures as below.
WACC measures a company’s cost of capital by proportionately weighing the debt and equity categories. It factors all capital sources such as bonds, preferred and common stock, and long-term and short-term debt. Higher values of WACC indicate declining valuation and increasing risk. Return on equity and the beta directly affect WACC (BlueBookAcademy.com, 2015). Assuming a corporate tax of 35%, WACC is calculated by multiplying E/V by RE, then adding it to D/V multiplied by RD and by one minus the tax rate. A reality check on the WACC value should show that it is in the single digits and is positive. Following the formula and corporate tax assumption given under instructions, Volkswagen AG’s WACC is calculated below.
Volkswagen’s WACC is below the industry average calculated as of January this year. The auto & truck industry has a WACC of 5.65% (Damodaran, 2021). Lower values indicate healthy companies, while higher figures are cause for concern (Advani, 2018). Therefore, Volkswagen’s lower WACC value shows that the company is paying less for its debt or equity when compared to the industry average. Such an outlook gives more returns to investors as valuation increases and assures potential shareholders that the organization can fund its projects through stock or bond issuing (Advani, 2018). Investors can also use the value of WACC to calculate the net present value (NPV) and internal rate of return (IRR) for investments and projects. In conclusion, Volkswagen AG’s WACC is better than the industry average and is a competitive investment option in the auto industry.
Advani, R. (2018). Chapter 8: Cost of capital. In R. Advani, Ed., The Wall Street MBA: Your personal crash course in corporate finance (3rd Ed.). McGraw-Hill.
BlueBookAcademy. (2015). Learn it FAST: Weighted average cost of capital explained. YouTube. Web.
Damodaran, A. (2021). Cost of capital by sector (US). Web.
Fidelity. (2021). Fixed income, bonds, & CDs. Fidelity. Web.
Fitch Ratings. (2021a). Volkswagen AG. Fitch Ratings. Web.
Fitch Ratings. (2021b). Fitch revises Volkswagen’s outlook to positive; Affirms at ‘BBB+.‘ Fitch Ratings. Web.
Infront Analytics. (2021). Levered/unlevered beta of Volkswagen AG. Infront Analytics. Web.
Moschella, J. (2019). Equity risk premium model. Gutenberg Research. Web.
Yahoo Finance. (2021). Volkswagen AG (Vow.de): Balance sheet. Yahoo Finance. Web.