6.2 Weighted Average Cost of Capital
6.2.2. Cost of Equity Capital
The NBC for BMW is thus calculated as follows:
This implies a cost of debt capital for BMW of 0.90 percent. It should be notet that this estimate is for the BMW Group as a whole, and not only the industrial business entity which is analyzed in the financial analysis.
However, Petersen and Plenborg (2012) argue that NBC rarely matches the firm’s true borrowing cost because NBC is affected by differences between rates of lending and deposits, and because several other items such as currency gains and losses on securities often are included in financial income and expenses. The net financial expenses for BMW comprise many different items such as losses and gains on derivatives, impairment losses on investments in subsidiaries amongst other (BMW Group 2012).
Furthermore, a 0.90 percent cost of debt for BMW would be lower than the 10-year German government bond rate, and would as such imply that BMW has a lower chance of defaulting on its bond payments than the country of Germany has on defaulting on its government bond payments, which does not seem to be a reasonable assumption. For these reasons it is not believed that the NBC of 0.90 percent reflects BMWs true borrowing cost. The cost of debt capital estimate of 2.80 percent as described above is regarded as a better estimate, and is as such used for calculating BMWs weighted average cost of capital.
Additionally, a company specific risk premium or liquidity premium may be added to the cost of equity capital derived from the CAPM if seen relevant (Damodaran 2005). However, the BMW Group has a total of more than 650 million shares outstanding on the Frankfurt Stock Exchange with an average trading volume of more than 2.5 million shares per day over the last three months according to data from Yahoo Finance (2012). As such, it is not regarded relevant to add a liquidity premium to the cost of equity capital for the BMW Group. Adding an additional risk premium to the CAPM model is not considered relevant for the BMW Group either, considering the company’s solid financial position, long history, strong brand name, and solid position in one of the World’s largest industries.
In the following sub-sections, the three above-mentioned components of the CAPM needed to estimate the cost of equity capital for the BMW Group are discussed.
188.8.131.52. The Risk-free Rate
As discussed in section 184.108.40.206 the rate of 10-year German government bonds was 1.83 percent as of January 1st 2012, and will also be used as the risk-free rate when estimating the cost of equity for BMW.
220.127.116.11. The Market Equity Risk Premium
The market equity risk premium represents the expected excess return that the overall stock market has over the risk-free rate. This can also be regarded as the rate of return an investor requires in order to invest in the stock market portfolio rather than in a risk-free asset.
According to Koller et al. (2010) the market risk premium may be estimated based on historical market returns, or by using regression analysis to link current market variables such as the aggregate dividend-to-price ratio to project the expected market risk premium. Koller et al. (2010) believes that the market risk premium varies continually between 4.5 and 5.5 percent based on evidence from these estimation models, and that the market risk premium equaled 5.4 percent as of May 2009.
Furthermore, Fernández et al. (2011) released a survey in May 2011 on equity risk premiums used by analysts, companies and professors in 56 countries at the time. On average, the 71 respondents in Germany used an equity risk premium of 5.4 percent, with a median of 5.0 percent. Fernández et al.
(2011) got very similar responses from 1,503 analysts, companies and professors in the United States, who reported an average equity risk premium of 5.5 percent, with a median of 5.0 percent.
103 Damodaran (2012) stimates an implied equity risk premium on the U.S. market every month, and estimated the equity risk premium to be 6.01 percent as of January 1st 2012. The survey of Fernández et al. (2011) suggests that analysts on the German market use very similar equity risk premiums as analysts in the United States. Furthermore, the 10-year U.S. treasury bond rate (regarded as the risk-free rate) was 1.88 percent as of January 1st 2012, almost identical to the 1.83 percent rate on German government bonds as of January 1st 2012. For these reasons, it is believed that Damodaran’s estimate of the equity risk premium on the U.S. market is also applicable to the German market. Therefore, Damodaran’s estimate of the market equity risk premium of 6.01 percent as of January 1st 2012 is applied when estimating BMW’s cost of equity capital.
18.104.22.168. Stock Specific Risk
According to the CAPM theory, the stock specific risk, or equity beta, measures the co-variation of the company stock returns with that of the stock market as a whole. If the beta is greater than 1, the volatility of the stock returns is greater than that of the market. If the beta is lower than 1, the volatility of the stock returns is lower than that of the market.
According to Koller et al. (2010) the future stock specific risk, or equity beta, is usually estimated based on historical stock returns. However, Petersen and Plenborg (2012) argue that estimating the stock specific risk based on historical returns has several weaknesses. Firstly, the company has to be listed on the stock exchange for a considerable amount of time in order to provide enough historical observations for the estimation. Secondly, the shares has to be traded frequently, or else the stock returns may appear to be very stable, leading to a low beta estimate that may not necessarily reflect the true underlying risk of the company. However, BMW stock has been quoted on the stock exchange since 1926 and is being traded in considerable volumes every day, as such, it is not believed that these specific weaknesses of estimating beta based on historical returns applies to the BMW stock.
Petersen and Plenborg (2012) further argue that the beta estimate is often not stable across time, which may reflect a true change in the underlying risk of the company, but may also imply measurement problems. According to Petersen and Plenborg (2012) the time interval that is used between each observation and the total time period of the observation may affect the beta estimate considerably.
Petersen and Plenborg (2012) also argue that the use of historical stock returns to measure the future stock specific risk may not be meaningful because the risk profile of the company may change over time.
104 The company may enter a new product segment, acquire another company, or make other strategic changes in the future that may affect the company risk profile. However, in lack of a better alternative, the use of historical returns is generally applied to estimate the future stock specific risk.
Koller et al. (2010) suggests that monthly returns should be used when estimating the stock specific risk based on historical returns, because daily or weekly returns may lead to systematic bias. Koller et al.
(2010) also argue that the stock returns should be regressed against a well-diversified market portfolio such as the Morgan Stanley Capital International (MSCI) World Index rather than a local country index, because most countries are not well-diversified, but rather heavily weighted in just a few industries.
Furthermore, Koller et al. (2010) suggests that the regression should include at least 60 data points in order to reduce estimation error.
As suggested by Koller et al. (2010), a regression of BMW’s stock returns against the MSCI World Index was run in order to estimate BMW’s stock specific risk:
The regression is based on monthly returns over the past five year period, from January 2007 to December 2011, with data gathered from Yahoo Finance and MSCI. The regression estimates a beta of 1.24 for the BMW stock, implying that the BMW stock is slightly more volatile than the overall stock market (represented by the MSCI index). However, the beta estimate has a standard error of 0.225, which yields a 95 percent confidence interval of 0.79 – 1.69. The high standard error is likely due to a relatively low number of data points (60). However, increasing the number of data points by using more frequent data may lead to systematic bias, and increasing the number of data points by increasing the time period may not be beneficial either. BMW may have had a somewhat different strategy and risk profile further back in time, and as such an estimate of future stock specific risk based on older data may not be as relevant as an estimate based on newer data. Further details on the regression results are included in appendix A.32.
To support the analysis of BMW’s stock specific risk, the beta estimates provided by some of the most used financial databases and web sites was gathered and is presented in table 1.22 below.
105 Table 1.22 – Beta estimates from various financial sources
Source BMW Beta
Thomson ONE Banker 1,24
(Source: Own creation, sources as listed)
As seen from table 1.22, the beta estimates provided by these sources are very similar to the regression estimate of 1.24. Both Thomson ONE Banker and World scope suggests an identical beta of 1.24, whereas the other sources suggest a slightly lower beta of 1.16 or 1.21. As such, it is believed that the regression estimate of 1.24 is a reasonable estimate for BMW’s future stock specific risk.
22.214.171.124. Cost of Equity Capital for BMW
The cost of equity capital for BMW is derived by utilizing the CAPM model and inputs as discussed above:
This yields an estimated cost of equity capital for BMW of 9,28 percent.