I was in college and just watched the movie “Wall Street” and like most young and naïve kids I became enamored with the world of finance.
Quite ironic that my first interest in capital markets came from a movie where the main characters are breaking the law.
Ha.
Anyways I chose my major and specialized in finance.
I thought they were going to teach me how to wear colorful suspenders, slick my hair back and talk like Gordon Gekko while flipping through my rolodex.
Nope.
They sat me down and taught me the the capital asset pricing model (CAPM).
Not exactly teaching me to perfect my “Greed is Good” speech.
Nonetheless, I dove right in.
Before we get started some boring housekeeping/finance stuff.
Below is the equation I use in this piece for the Weighted Average Cost of Capital (WACC).
W.A.C.C. = [Cost of Equity x Equity %] + [After Tax Cost of Debt x Debt %] + [Cost of Preferred stock x Preferred %]
Cost of equity, Ke = Risk free rate + Beta (10 yr trailing return S&P 500 - Risk free rate)
Risk Free rate = 10 U.S. treasury
Beta = Correlation Coefficient (stock price, S&P 500) x [standard deviation monthly stock price / standard deviation monthly S&P 500]
After Tax Cost of Debt = Kd = (interest expense/average debt) x (1 - tax rate)
Cost of Preferred = Preferred Dividend/ average BV preferred.
Equity/Debt/Preferred %‘s= book value of shareholders’ equity or debt or preferred divided by sum of the three
I realize that some of you guys and gals may disagree with how I calculate the cost of capital. For example I should use market values instead of book value or some may point out that equity betas are determined by the volatility in the futures markets, etc
But the main thing I wanted to do was remain consistent over time as well as put some of that CFA-ing to work.
Using my Crude Chronicle Energy Index (CCEI), I decided to calculate the theoretical cost of equity for the oil & gas industry.
The chart below is what I came up with.
A couple takeaways from this chart.
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