6. FINANCIAL ANALYSIS AND VALUATION
6.3. V ALUATION
6.3.2. Weighted average cost of capital (WACC)
To be able to apply the valuation model, the WACC is to be estimated based on the cost of equity, cost of debt and the capital structure. The following formula illustrates how cost of equity, cost of debt and the capital structure would affect the level of WACC:
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WACC = NIBL
(NIBL Equity)x r x (1-t) +(NIBL EquityEquity )x r Where
NIBL = Net interest-bearing liabilities Re = Required rate of return on equity Rd = Required rate of return on debt t = Tax
For instance, under the assumption that cost of debt is lower than cost of equity, a higher financial leverage would lower WACC. However, it is worth mentioning that the capital structure of a firm affects its default risk, which influences its cost of debt.
Cost of equity
Generally speaking, a firm’ operation is financed with equity and debt. Cost of equity is the required rate of return of equity investors (Petersen et al., 2017). To calculate the cost of equity, the Capital Asset Pricing Model (CAPM) was used in this thesis. Hence the calculate of equity investors’ required rate of return can be specified as:
re = rf + βe x (rm - rf)
risk premium where
Rf = Risk-free interest rate Rm = Return on market portfolio βe = Systematic risk of the equity
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In order to calculate the required return of Vestas’ shareholders, it is required to estimate the risk-free interest rate, market return and beta value of Vestas.
Risk-free rate
The risk-free rate was estimated based on the yield of the 10-Year Euro Area Zero-coupon Government Bond in the past 5 years (ECB, n.d). Figure 18 shows the past 5 years’ yield curve of the 10-Year Euro Area Zero-coupon Government Bond and an average annual yield was calculated, which provided a reasonable estimate of the risk-free rate at 0.074%.
Figure 18: Last 5 years yields development for the 10-Year Euro Area Zero-coupon Government Bond (Source: ECB, n.d.)
Market return
STOXX Europe 600 Index was chosen as the market benchmark, as the currency is in euro which aligns with the currency used in Vestas’ financial reports. Additionally, the index is consisted of 600 listed European stocks among 17 European countries, covering diverse
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industries, which was presumed to be a better proxy of the market portfolio than the OMX C25, given the OMX C25 index is heavily weighted towards the pharmaceutical sector. As of Mar. 31, 2021, the annualized return of STOXX Europe 600 Index based on the last five years’
market data is 8,5% (Figure 19; STOXX.com, n.d.), which was used in this thesis as the market return.
Figure 19: Risk and return of STOXX Europe 600 Index. (Source: STOXX.com, n.d.)
Equity beta (βe)
Beta is a measure of the systematic risk of a company’s stock in comparison to the overall market. If the beta is greater than 1, then the firm’s stock is more volatile and will outperform the market if the market is going up and underperform the market if the is market going down.
Conversely, if the beta reacts less than the market, then the beta is less than 1. In other words, a high beta is riskier but at the same time can potentially give a higher return (Petersen et al., 2017).
A firm’s beta can be calculated based on the historical stock returns (Petersen et al., 2017).
Thus, the past five years’ daily returns were used to measure Vestas’ beta against STOXX Europe 600 Index. Given that Vestas’s stock price is in DKK, the daily stock price was first converted to EURO based on the daily spot exchange rate before calculating the daily return.
The daily returns of both Vestas’ shares and STOXX Europe 600 Index over the past five years were plotted in Figure 20. According to the calculation (Figure 21) based on the following
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formula, Vestas’ beta against STOXX Europe 600 Index was 0,965.
Figure 20: Daily returns of Vestas’ stock and the STOXX Europe 600 Index over the past five years (the authors’ own creation)
Figure 21: Covariance matrix, own creation
Consequently, the estimated required rate of return on Vestas’ equity was equal to:
r
e = rf + βe x (rm - rf)98
r
e = 0.074% + 0.965 (8.5% -0.074%)r
e = 8.21%Cost of debt
The cost of debt is the required rate of return on debt from the lenders who finance the firm with debt (Petersen et al., 2017). The lenders require a premium for default risk and the cost of debt can be calculated as:
r
d= (r
f+ r
s) *(1-t)
Where
R
s = risk premium on debt (Credit Spread)The estimated risk-free rate (rf) known from the previous section is 0.074%. The credit spread (rs) is the risk premium on debt (Petersen et al., 2017). There are 2 approaches to estimate the cost of debt. One way is to look at the yield to maturity of the company’s issued debt (CFI, 2020). In this context, Vestas in 2015 issued a green bond with an interest rate of 2.75%, which might not be suitable to reflect Vestas’ current cost of debt as the bond issued was 500m EURO with the current book value of 498m EURO which accounts for only 36.78%
of its total debt (Vestas, 2020a). The rapid change of the wind turbine market also increases the complexity of determining the cost of debt. Another way is to look at its credit rating and to determine its credit spread based on the given rating (CFI, 2020). According to Moody’s
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Investors Service, Vestas has recently been assigned a Baa1 long-term issuer credit rating (Moody's, 2021). Based on the given Baa1 rating, the credit spread was estimated to be 1.71%, according to professor Damodaran’s data page (Damodaran, 2021).
The corporate tax rate in Denmark is reported in its annual report of 22%, however as Vestas operates in different global regions which have different tax rates (Vestas, 2020a; figure 22), the forecasted effective tax rate of 23.5% will be more appropriate to calculate the cost of debt.
Figure 22: Vestas Tax structure (Source: vestas, 2020a)
To sum up, the cost of debt after tax shield is equal to
r
d after tax shield =(r
f+ r
s) *(1-t)
r
d after tax shield = (0,074%+1.71%) x (1-23.5%)r
d after tax shield= 1.36%Extant literature shows that environmental externalities impose reputational, financial, and litigation related risks on corporations and which can have direct implications for a firm’s cost of debt (Clark et al., 2015). By implementing ESG policies to reduce such risks, companies
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can lower the cost of debt, for instance, research documented that good corporate governance significantly decreases borrowing costs (Clark et al., 2015). Firms implementing initiatives to improve employee well-being can have better credit rating and has a lower probability of bankruptcy because they are more likely to repay the loan (Verwijmeren & Derwall, 2010).
Firms proactively engage in environmental improvement are charged a lower cost of debt and reversely firms with significant environmental concerns have to pay a higher premium on their loans and have a lower credit rating (Bauer and Hann, 2010). Schenider (2011) conducting a study in 48 firms in the pulp and paper industry and chemical industry found that poor environmental performance can face liability risk in future cleanup and compliance fines costs which can be large enough to threaten the polluting firms not be able to meet their fixed payments to creditors.
Moody’s rating of Vestas has already taken in the consideration of Vestas’ sustainability profile which is the key driver of Moody’s decision on rating Vestas Baa1. The reasoning behind the rating with Moody’s own words is “with its market leading position in the wind turbine business, will benefit from the global efforts to reduce carbon dioxide emission and the trend towards renewable energy sources in combination...” (Moody's, 2021). This aligns with the above-mentioned findings that firms devote in sustainability can have a better credit rating and a lower cost of debt. It is recently observed on Nasdaq that the green bonds issued in Nordic are at a relative low interest rates level (Nasdaq, 2021). To wit, the estimate of 1.36% was believed to be a reasonable assumption.
The calculation of WACC
It is recommended that the capital structure should be based on market values, given that it could better reflect the true opportunity cost of investors (Petersen et al., 2017). As it is difficult to estimate the market value of debt, the book value would be used as a proxy. As of 29th of
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April, Vestas has a number of 1,009,867,260 outstanding shares in total (Vestas, n.d.) with a closing price of 258.20 DKK at the day. The closing exchange rate of EURO to DKK was 7.4353, which resulted in a market capitalization of 35,069 mEUR. With a net financial asset value of 2361.07 mEUR at the end of 2020, it was assumed that Vestas’ financial assets shared the same level of risk as its debts, which would produce the same level of expected return.
Consequently, the WACC was estimated to be at 8.7% as below calculation, under the assumption that the capital structure remains constant. The reason that the market value of equity on 29th of April 2021 was chosen to calculate the capital structure was that the authors believed it could better reflect the long-term capital structure.
WACC = NIBL
(NIBL Equity)x r x (1-t) +(NIBL EquityEquity )x r Which in our case is
WACC =( MVE
MVE - NFA)x r −(MVE - NFANFA )x r x (1-t) Where r =r
WACC =( 35069
35069- 2361.07)x 8.21%−(35069- 2361.072361.07 )x 1.36%
WACC = 8.7%