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Cost of Capital report – FIN 503

Submitted by: Amandeep Arora (1441665), Abhineet Kansal (), Avrojit Roy (), Maaz Gabbur ()

Introduction to Lear Corporation

Assumptions for WACC calculation:

1. 

Risk free rate of return for a given time horizon is taken from yield on government bonds for that

time horizon

2.  Estimated market risk premium is assumed as 6.5% for calculation purposes

3.  The company hasn’t further bifurcated cash and cash equivalents in schedules to balance sheet.

But it mentioned that it has invested some part of cash equivalents in money market instruments.

Hence we assumed the excess cash as 25% of the total cash and cash equivalents which is

deducted to total debt to calculate net debt.

4.  Lear Corporation has credit rating of Baa3 from Moody’s. The synthetic credit spread for Baa3

rating is taken as 2.25%.

5. 

Tax rate is assumed as 30%.

Weighted average cost of capital (WACC)

WACC of Lear Corporation = Cost of Lear’s debt + Cost of Lear’s equity (for a particular time horizon)

Cost of Debt

It is referred as the effective rate that a company pays on its current debt. This can be measured in either

before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen

most often. This is one part of the company's capital structure, which also includes the cost of equity.

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Cost of Lear ’s debt  

Risk free rate for 10 years time horizon is 3.61%. The synthetic credit spread for Baa3 rating is assumed as

2.25%. Hence, cost of debt for 10 year horizon for Lear ’s Corporation is computed as summation of risk

free rate and synthetic credit spread i.e. 5.86% (3.61% + 2.25%). The detailed calculations of cost of debt

for various time horizons can be referred in Appendix.

 Alternate way: Cost of debt can also be defined as the ratio of interest expense and total net debt. Hence

the calculation of cost of debt using this method is shown in Appendix. The cost of debt for 2013

calculated using this formula i.e. 6.04% is very close to cost of debt calculated by using 10 years risk free

rate as mentioned above. 

Cost of Equity

Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of

return that could have been earned by putting the same money into a different investment with equal

risk.

Cost of Lear ’s equity  

Cost of equity is calculated as:

As assumed in calculation of debt cost, risk free rate for 10 years time horizon is 3.61%. The beta for the

Lear’s stock is calculated by using regression analysis of the weekly returns  of NYSE composite index and

Lear’s stock that is traded on NYSE. Beta is the value of coefficient of X in regression output. 

 Alternate way: Beta can also be calculated using a slope function.

Beta = “=SLOPE(H4:H159,E4:E159)” 

where values in column ‘H’ represents weekly returns on Lear’s stock and values in column ‘E’ represents

weekly returns on NYSE Composite Index.

Weighted average cost of capital (WACC)

WACC = {(Debt/Debt+Equity)* Cost of debt} + {(Equity/Debt+Equity)* Cost of equity}

Total debt during the end of 2013 for Lear Corporation is $792.82 mn and total equity at this time is

$3045.1 mn. The values of cost of debt and equity for various time horizons are plugged in the above

formula to calculate the weighted average cost of capital for various capital horizons.

WACC for 10 year time horizon = {(792.83/792.83+3045.1)* 5.86} + {(3045.1/792.83+3045.1)* 3.61}

= 11.62%

E,t rf,t m rf  

Market Risk Premium

r r r r

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Appendix

Regression output for calculation of Beta

Cost of Debt  Alternate calculation:

Risk free rate assumption 3.61%

Synthetic credit spread 2.25% For Baa3 rating

Years (Time Horizon) Risk free rate Cost of debt

1 0.30% 2.55%

2 0.79% 3.04%

3 1.36% 3.61%

5 2.34% 4.59%10 3.61% 5.86%

SUMMARY

OUTPUT

Regression Statistics

Multiple R 0.698937847

R Square 0.488514115

Adjusted R

Square

0.485192778

Standard

Error

0.023964556

Observatio

ns

156

ANOVA

df SS MS F Significance

F 

Regression 1 0.084470087 0.08447009 147.083577 3.4702E-24

Res idual 154 0.088442188 0.0005743

Total 155 0.172912275

Coefficients Standard

Error 

t Stat P-value Lower 95% Upper 95% Lower

95.0%

Upper

95.0%

Intercept 0.002942323 0.001931585 1.52326891 0.12974229 -0.0008735 0.00675815 -0.0008735 0.00675815

X Variable

1

1.463610792 0.120682281 12.1278018 3.4702E-24 1.22520439 1.70201719 1.22520439 1.70201719

Beta

Cost of Debt 2013

Total interest

incurred

68.4

Total debt (A) 1057.1

Excess cash (B) 264.275

Net debt (A-B) 792.825

Cost of debt 8.63%

After tax cost ofdebt (tax rate

30%)

6.04%

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Cost of equity

Beta for Lear = 1.463610792 (Coefficient of X in regression output)

Market risk premium = 6.50% (Estimated equity risk premium)

Years (Time

Horizon)

Risk free

rate

Cost of

equity

1 0.30% 9.81%

2 0.79% 10.30%

3 1.36% 10.87%

5 2.34% 11.85%

10 3.61% 13.12%

Weighted average cost of capital (WACC)

Total Debt in 2013 (D) = $ 792.825 mn net of excess cash

Total Equity in 2013 (E) = $ 3045.1 mn

Therefore, D/(D+E) = 0.207 and E/(D+E) = 0.793

Years (Time

Horizon)

Cost of debt Cost of

equity

WACC

1 2.55% 9.81% 8.31%

2 3.04% 10.30% 8.80%

3 3.61% 10.87% 9.37%

5 4.59% 11.85% 10.35%

10 5.86% 13.12% 11.62%