Balance of Payments

WEIGHTED-AVERAGE COST OF CAPITAL

The weighted-average cost of capital (WACC) for a company represents the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital. The basic formula1 is shown here: E D R  K  K (1 t ) WACC D  E E D  E D C where, E = the market value of equity D = the company’s debt

KE = the cost of equity (CAPM) KD = the cost of debt tc = corporate tax rate Bloomberg WACC for Staples (NYSE: SPLS):

As you can see from the figure above, Bloomberg distinguishes between the short and long term debt and includes preferred equity (if any). This expanded formula is shown below. E D P R= K + K(1 - t ) + K WACCV E V D C V P where, E = the market value of equity D = the company’s debt P = the company’s preferred stock V = The total value of the company’s (E)quity + (D)ebt + (P)referred stock. KE = the cost of equity (CAPM) KD = the cost of debt 2 KP = the cost of the preferred stock tc = corporate tax rate

1 The formula can become more complex with a more complicated capital structure, as different weights and costs are assigned to various securities (i.e. preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, etc.). 2 Note: Since preferred dividends are not tax deductible, there is no adjustment for tax. The cost of preferred stock can be calculated using the preferred dividend (DPS), the preferred stock price (PPS), and the flotation (or underwriting) cost as a

DPS percentage of proceeds (F). KP = . Flotation costs for preferred stock range from 2-6% of proceeds. PPS (1- F ) Bloomberg WACC 1 Capital Structure : The capital structure used in the WACC calculation should be based on market values rather than book values because we are concerned with estimating how much it will cost a company to raise the capital today (this cost is best estimated based on “market” rather than “book” or “accounting” figures). Target weights may also be used in calculating WACC since companies will often lever up or down toward a desired debt–equity weighting. Note: this is usually towards the average debt-equity weighting in their industry or peer group.

The Capital Structure for SPLS consists of the following elements  Common Equity (see note #1) 97.88%  Short-term debt 0.14%  Long-term debt 1.99%  Preferred equity + 0% 100%

Bloomberg WACC 2 1) Market Capitalization – Bloomberg calculates “Common Equity” using the shares outstanding from the latest period company statement multiplied by the closing prices as of the fiscal end date.

To view the data behind this figure you can type: “SPLS Equity FA” Select 1) Overview:

Select 15) Hist market cap:

Select 3) Data Transparency:

Bloomberg WACC 3 Select 5) 02/2008 16861980.00:

You can now click “2008 Shares Outstanding”, which will give you the unadjusted values (i.e. the number of shares issued 867,366,103 and the treasury stock 162,728,588):

If you click on these figures, Bloomberg will take you to the page of the financial statements where the figure was pulled and will highlight the figure. For example in the case for shares outstanding you will be brought to the Balance Sheet on page C-3 of Staples 2007 10K:

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,560,728 $ 1,486,188 Accrued expenses and other current liabilities 1,025,364 1,087,030 Debt maturing within one year 23,806 215,165

Total current liabilities 2,609,898 2,788,383

Long-term debt 342,169 316,465 Other long-term obligations 356,043 261,643 Minority interest 10,227 9,109

Stockholders' Equity: Preferred stock, $.01 par value, 5,000,000 shares authorized; no shares issued — — Common stock, $.0006 par value, 2,100,000,000 shares authorized; issued 867,366,103 shares at February 2, 2008 and 849,338,568 shares at February 3, 2007 520 510 Additional paid-in capital 3,720,319 3,338,412 Cumulative foreign currency translation adjustments 476,399 189,115 Retained earnings 4,793,542 4,005,424 Less: treasury stock at cost, 162,728,588 shares at February 2, 2008 and 130,605,591 shares at February 3, 2007 (3,272,773) (2,511,796)

Total stockholders' equity 5,718,007 5,021,665

Total liabilities and stockholders' equity $ 9,036,344 $ 8,397,265

Bloomberg WACC 4 Cost of Equity – The cost of equity that Bloomberg uses is derived from the CAPM model:

CAPM= rf +b ( r m - r f ) Note: The discrepancies to the figures in the table below are a result of rounding. CAPM =3.3% + 1.07( 10.27% - 3.33%) = 10.75%

Note: CAPM = 14.10% + 1.26 (11.72% - 2.57%) = 25.63% Equity Risk Premium = 1.26 (11.72% - 2.57%) = 11.53% Country Premium = 11.72% – 2.57% = 9.15 %

In Bloomberg, if you would like to update the market capitalization figure used in the equation, it can be changed here - all other cost of equity variables can also be changed in this window.

1) Risk Free Rate – is equal to the yield of the 10-year treasury (see below). Bloomberg constantly updates this figure during market hours to reflect the current yield.

To view the data behind the risk free rate you can type: “CT10 Govt HP”

Bloomberg WACC 5 2) Expected Market Return - The expected market return is based on the dividend discount model.

Cost of Debt – The pre-tax cost of long term debt is based on the company’s credit rating. The lower the rating the higher the factor.

The “debt adjustment factor” used in the calculation is based on the average yield spread between corporate bonds for a given credit class and government bonds.

Cost of Debt = { [(SD/TD) x (TN x AF)] + [(LD/TD) x (TB x AF)] } x [1 – TR] Where; SD = Short Term Debt LD = Long Term Debt TD = Total Debt AF = Debt Adjustment Factor TN = Avg. Rate of Treasury Notes TB = Treasury Bond Rate TR = Tax Rate Example:

Bloomberg WACC 6 On 12/3 (shown below) 10 year bonds were yielding 7.0161%, this is the “Pre-tax Cost L.T. Debt”

Net Operating Profit After Tax (NOPAT) is the after-tax profit a company would have if it had no debt and no investments in non-operating assets. Because it excludes the effects of financial decisions, it is a better measure of operating performance than net income.3

NOPAT ≈ EBIT(1-tax rate) (update: economic value add)

Bloomberg NOPAT = Net Operating Profit – Cash Operating Taxes:

Economic Value Added:

3 Note: This is a basic formula, Bloomberg calculates NOPAT = Net Operating Profit – Cash Operating Taxes. In addition Case Studies in Corporate Finance, p. 218 notes that adjustments might include adding back goodwill, amortization, and other noncash expenses. Taxes should be adjusted to reflect only actual cash taxes. Finally depreciation is not added back (despite being a noncash expense) because depreciation represents a true economic cost – it is the amount that must be reinvested to maintain operations at the existing level. Bloomberg WACC 7 Total Invested Capital – is a measure of the economic capital from shareholders, lenders and other financial resources that is tied up in the business for the purpose of funding the company operations. It is derived by deducting non-financing accounts such as account payables and accrued expenses, capitalizing several types of expenses and adding off-balance sheet items to total liabilities and equity.

Bloomberg WACC 8 Return on Invested Capital (ROIC) = is the ratio of NOPAT to total operating capital (Note: value creation entails generating after-tax cash returns above the cost of capital invested in the business).

ROIC = NOPAT / Total Operating Capital Where, Operating Capital = NOWC + Net fixed assets NOWC = Operating Current Assets – Operating Current Liabilities Operating current assets = [cash + inventory + receivables] Operating current liabilities = [accounts payable + accruals]

EVA & EVA Spread

EVA = NOPAT – Capital Charge; where Capital Charge = (WACC %) x (Total Invested Capital)

EVA Spread = ROIC% - WACC %

Graduate Assistant, John Giannantonio helped to prepare this class note.

Bloomberg WACC 9