WACC, Payout Ratio, and Future Prospects for BHP Group (Case Study Sample)

Report 3: WACC, Payout Ratio, and Future Prospects for BHP Group
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WACC
1 Computing BHP's WACC
The Weighted Average Cost of Capital (WACC) refers to the average expected rate that a firm is expected to pay its security holders for financing its assets. As the firm's average cost of capital, it uses weights to measure the burden of a firm's sources of funds both from Debt and equity proportionately. WACC is a vital finance aspect as it allows investors and managers to gauge whether projects meet and exceed the cost of invested capital. If the project's returns are inferior to the firm's expected WACC, then the project should be discarded as the cost of handling the projects falls below the firm's price of capital. Although the method uses some assumptions, it is a quick enabler in making prompt decisions.
The Weighted Average Cost of Capital (WACC) is computed using the following formula:
WACC=EE+D*Cost of Equity+DE+D*Cost of Debt*1-Tax rate
where
E is the market value of the firm's equity Market capitalization
D is the market value of the firm'sdebt
BHP's Group's market capitalization from Yahoo Finance is $130.233 billion
BHP's book value of Debt as indicated by the latest financial year (2020) was $52.537 billion
The corporate tax rate in Australia is 27.5%
The cost of Debt is computed using the latest annual report by comparing the yearly interest expense with the Debt's book value as follows:
Annual interest (2020) is $881,000,000
Book value of Debt (2020) $52,537,000,000
Cost of debt=Annual interestBook value of debt*100
=881,000,00052,537,000,000
=1.68%
Cost of Equity
Using CAPM, the cost of equity can be computed from the following formula:
Cost of Equity = RiskFree Rate of Return + Beta of Asset * (Expected Market Return- RiskFree Rate of Return)
Using the 10-Year Treasury Constant Maturity Rate as the Risk-Free Rate, Trading Economics (2020) estimates the Risk-free rate at 0.87%
The Asset Beta, which represents its volatility from Yahoo Finance, is 0.98. A beta greater than one indicates that a firm's stock is more volatile than the market, while below one shows that the stock is not as volatile as the market. BHP's beta thus has lower volatility than the market.
The expected market return-risk-free return rate, also known as the market premium, has been held at 6%. It represents the additional return that an investor expects to receive over holding a risky portfolio rather than risk-free assets.
Therefore, the cost of equity is 0.87%+0.98*6%
=6.75%
Applying the WACC variables to the formula:
WACC=130.233130.233+52.537*6.75%+52.537130.233+52.537*1.68%*1-27.5%
=5.16%
It indicates that BHP Group pays 5.16 cents for every dollar extended to it as a finance form. Any project presented to the firm should have a higher than 5.16% rate of return to justify taking finances from the sources it uses.
2 Assuming that BHP had no debt
If BHP had no debt, and all other variables remained constant, then the following would ensue:
WACC=EE+D*Cost of Equity+DE+D*Cost of Debt*1-Tax rate
But now, debt=0 and the cost of debt=0
where
E is the market value of the firm's equity Market capitalization
D is the market value of the firm'sdebt
BHP's Group's market capitalization from Yahoo Finance is $130.233 billion
Assuming BHP's book value of Debt is 0
The corporate tax rate in Australia is 27.5%
The cost of Debt is computed using the latest annual report by comparing the yearly interest expense with the Debt's book value as follows:
Annual interest (2020) is $0
Book value of Debt (2020) $0
Cost of debt=Annual interestBook value of debt*100
=00
=0%
Cost of Equity
Using CAPM, the cost of equity can be computed from the following formula:
Cost of Equity = RiskFree Rate of Return + Beta of Asset * (Expected Market Return- RiskFree Rate of Return)
Using the 10-Year Treasury Constant Maturity Rate as the Risk-Free Rate, Trading Economics (2020) estimates the Risk-free rate at 0.87%
The Asset Beta, which represents its volatility from Yahoo Finance, is 0.98
The expected market return-risk-free return rate is also known as the market premium, has been held at 6%.
Therefore, the cost of equity is 0.87%+0.98*6%
=6.75%
WACC=130.233130.233+0*6.75%+0130.233+0*0%*1-27.5%
=6.75%
From the above computations, the WACC for BHP was 5.16% when Debt was included but increased to 6.75% when excluding Debt and debt costs. It indicates that while the average cost of a dollar of finance with Debt was 5.16 cents, the average cost without Debt would be higher to 6.75 cents for every dollar of finance. The findings align with the assertion that equity financing is more expensive than debt financing, given the investor's risk and the flexibility accorded. Debt financing is not as risky to the lender as equity finance is risky to the investor. Applying the findings, WACC is an average figure that includes Debt and equity finances' weights, inferring that it lowers the cost of equity financing, which is always higher due to its risk. Removing the lower debt-financing value leaves equity financing more elevated than the average cost of capital. The debt weight reduces the weight of capital funds acquired from finance sources.
Adjusting for Credit Risk
3 BHP Group's Credit Rating
According to Moody's credit rating, BHP Group has a rating of A2 on long-term ratings indicating that it has a strong capacity and ability to handle its financial commitments. However, the rating also notes that despite the strong position, the firm may be susceptible to adverse impacts on the business as occasioned by economic and other conditions relied on the obligor.
4 Credit Spreads
* Revise the Cost of Debt and WACC for your company using the credit spread from iTraxx
The awareness of credit spreads may also be used to derive the Cost of Debt for a firm. The credit spread indicates the credit risk that s associated with a company. It can compute the cost of Debt using the following formula:
kd (1-T) = (Risk free rate + Credit spread) (1-T)
Risk-free rate 0.87%
Credit spread for B2 rated bonds (Theoretical Spread) 136.18
Tax rate =27.5%
kd 1-T= Risk free rate + Credit spread1-T
=0.87%+1.3618%
=2.23%
WACC=EE+D*Cost of Equity+DE+D*Cost of Debt*1-Tax rate
WACC=130.233130.233+52.537*6.75%+52.537130.233+52.537*2.23%*1-27.5%
=5.27%
* Presenting BHP's Estimated WACC to the CFO
As noted above, BHP Group has been rated B2 by Moody's, indicating that it has strong potential in honoring commitments under stable conditions (Moody's, 2020). However, unforeseen events and economic or environmental upheavals may disrupt the firm's operations and its ability to honor its commitments to obligations. Presenting the information to the CFO is critical, considering that the use of the credit spread raises the firm's cost of Debt and, overall, raises the cost of capital. The increased cost of capital also means that the firm's expenses increase while the net profits reduce.
5 Investment and Financing
$ in Billions

2016

2017

2018

2019

2020

Capital Expenditures (PPE)

9.55

4.9

6.43

8.74

10.29

Outstanding PPEs

110.49

103.08

88.74

94.65

102.02

The firm's capital expenditure in fixed properties has varied over the period, as indicated in its cash flow statement. In 2016, the firm spent $9.55 billion, which only reduced in 2017 when the firm spent $4.9 billion. However, in 2018, the firm increased its spending to $6.43 billion, then expanded its spending to $8.74 in 2019, which later rose to $10.29 billion in 2020. However, despite the notable increments in expenditures for the PPEs, the outstanding net value of the PPEs on the firm's balance sheet has decreased considerably from $110.49 billion to $103.08 billion, then o $88.74 billion in 2018. The firm then noted a rise to $94.65 billion in 2019 and then increased to $102.02 billion. The outstanding net value coincides with the spending in the PPEs, although the notable decreases can be attributed to depreciation while other portions may have been written down.
6 PPE Investment Vs. External Financing
Th investment in PPE and external financing have no linear relationship for BHP Group. The firm only acquired $6.33 billion for the last five years and has spent an extended period repaying the Debt. In 2017, it repaid $7.29 billion Debt; in 2018, it repaid $5 billion Debt, while in 2019, it repaid $3.52 billion, and $2.52 billion in 2020. Despite the repayments, the firm noted increases in the PPEs, indicating that the firm does not rely on external funding to purchase fixed properties. Other sources of finances for the firm include plowing back pr...