Weighted average cost of capital of Honeywell International Inc

(Source: created by author)

The above calculation shows that the dividend growth rate to be taken for the purpose of calculation is 12%. The current year’s dividend is $2.15. The current market price of the share is $124.56. The calculation for cost of equity is given below:

R_E = {[D₀* (1+g)] /P₀} + g

= ((2.15 X (1+12%)/124.56) + 12%

= 13.93%.

Based on the above calculation the cost of equity is calculated to be 13.93% by using the dividend growth model.

3.1.3 Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method

This is another method that can be used for calculating the cost of equity. In this method the cost of equity is calculated by adding the equity risk premium with the long term yield of the bond. If the cost of equity is widely different under CAPM method and dividend growth method then it acts as an important check (Allcott & Wozny, 2014). The market risk premium for the stock is the difference between the return from the stock and risk free return. The discussion earlier have shown that the risk free return for marketable securities is 2.04% and the market return is 11%. Therefore, it can be said that the risk premium is 9% (approx.). The cost of debt calculated earlier is 14%. The formula for calculation is given below:

R_E = R_D + Judgmental risk premium

= 14% + 9%

=23%

Therefore, based on the above calculation it can be said that the cost of equity under this method is 23%.

3.1.4 Selecting the cost of equity

The discussion above shows that there are three methods that have been applied for calculating the cost of equity. The cost of equity using the CAPM method is 8%, and dividend discount method is 14%. The cost of equity under this two method differs widely so Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method is used for verifying the cost of equity (Fang et al., 2015). The cost of equity in this method is 23%. Therefore, based on the above discussion the cost of equity that is taken for calculating the cost of capital is the average of the three and it comes to 15.5% as it is between the two extremes.

3.2 Cost of Preferred Stock

The cost of preferred stock is the rate of return that is required by the preference shareholders. It is calculated by dividing the annual dividend with the current market price of the share (Robinson et al., 2016). The formula is given below:

R_PF = Dividend/P₀

In this case, the company does not have any preferred stock. Therefore the cost of preferred is not calculated.

3.3 Cost of Debt

The cost of debt is referred to as the effective rate of interest that the company pays for using the debt capital. The company uses various bonds, debts and loans so the calculation of the cost of debt is essential because it gives an idea of the cost incurred by the company for overall debt financing (DiMasi et al., 2016). The cost of debt incurred by the company is calculated by dividing the total interest paid by the company with the total debt. The calculation is provided in the Annexure 3 and it can be seen from the calculation that the cost of debt is 3%. The after tax cost of debt is calculated by multiplying the cost of debt with the marginal tax rate.

The cost of debt is calculated using the market value method. In this method the market value of each bond is calculated. Then the yield to maturity of each bond is multiplied with the weightage of market of bond for calculating the cost of debt (Li et al., 2013). The calculation showing the cost of debt is provided in Annexure 3. Therefore, based on the calculation it can be said that the cost of debt based on the weighted market value of debt is 14%. The 14% cost of debt will be used for calculating the weighted average cost of capital.

3.4 Market Value of Debt

The market value of debt is calculated by multiplying the price with the number of bonds. The calculation of market value of debt is provided in Annexure 3. The calculation shows that the total market value of the debt as the $13705.48 million. In addition to this any other long term leases from the balance sheet should be added with bonds to find the total market value of debt (Jenter & Kanaan, 2015). In this case, the company does not have any long-term lease in the balance sheet so the market value of the debt will be the same as provided in the Annexure 3.

3.5 Market Value of Equity

The market price of equity is calculated by multiplying the current market price of shares with the number of stock outstanding (Acharya et al., 2017). The current market price of shares is $124.56. The total number of shares outstanding as at 2015 year ending is 770.4 million. Therefore the total market value of equity is (124.56 X 770.4) $95961.02 million.

3.6 Market Value of Preferred Stock

The company does not have any preferred stock. Therefore, calculation of market value pf preference share is not required in this case.

3.7 Value of Firm

The total value of the firm is determined by calculating the Enterprise value. The enterprise value is an alternative method for determining to equity market capitalization for calculating the market value of equity (Hann et al., 2013). The formula that is used for calculating the Enterprise value is given below:

Enterprise Value= market value of equity+ market value of preferred stock + market value of debt + minority interest – cash and investments.

In this case, the calculation showing the enterprise value of the company is provided below:

Table 2: Enterprise Value

(Source: created by author)

The calculation above shows the Enterprise value of the firm and it comes to $104346.51 million.

3.8 Firm’s Tax Rate

The tax rate of the business can be calculated by referring to the annual report of the company. The tax rate is calculated by dividing the tax paid with the earnings before interest and taxes. The calculation is provided below:

Table 3: Tax Rate

(Source: created by author)

The calculation above shows that the tax are for the company is 26%.

3.9 Weight for Equity

In order to calculate the WACC the weightage that is used is the market value of equity. In this case, the market value of equity is $95961.02.

3.10 Weight for Preferred Stock

In this case, the company does not have any preference shares. Therefore, no weightage is calculated.

3.11 Weight for Debt

The market value of debt is used as the weightage for calculating the weighted average cost of capital. The market value of debt is $13705.48.

3.12 WACC (Weighted Average Cost of Capital)

The weighted average cost of capital is the minimum after tax return that the company should earn for all its stakeholders. This calculated after ascertaining each component of the capital structure of the company (Lai et al., 2014). The WACC is an important tool for determining whether the company is increasing wealth or is just covering the cost. The formula for calculating the WACC is given below:

WACC = [(w_E) x R_E] + [(w_PF) x R_PF] + [(w_D) x R_D x (1- T_C)]

Where:

Weights

(w_E) = % of common equity in capital structure

(w_PF) = % of preferred stock in capital structure

(w_D) = % of debt in capital structure

Component costs

R_E = firm’s cost of equity

R_PF = firm’s cost of preferred stock

R_D = firm’s cost of debt

T_C = firm’s corporate tax rate

The calculation of the WACC of the Honeywell International Inc. is provided in the Annexure 4. Therefore, it can be said that the WACC of the company is 14.17%.

4. Assumptions

The calculation of WACC involves making certain reasonable assumptions. The significant assumptions that have been made have been provided below:

• It is assumed that the return received from the treasury bond is regarded as the risk free rate of return.
• It is assumed that the market rate of return is the return of S&P index.
• It is assumed that the future dividends will grow at the historical rates.
• It is assumed that the cost of equity is the average of cost that is determined from the three methods.

5. Conclusion

The above discussion shows the calculation of the weighted average cost of capital. Based on the above discussion it can be said that the process of ascertaining the cost of capital involves making some assumptions. In this case, the weighted average cost of capital of the company is calculated to be 14.17%.

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