WACC function automatically calculates costs of equity and debt.
The cost of debt is calculated from the yield of a company’s bonds. Facebook does not have bonds. That is why the cost of debt is 0.
The calculation of the cost of equity is more complicated. The calculation is called ‘capital asset pricing model’.
Involved steps are:
look into the general riskiness of the stock market
evaluate the volatility of the stock and compare it to the overall market
calculate stock specific risk
Cost of equity can be estimated within the Bloomberg Terminal.
The U.S. treasury bond yield usually is the baseline for the discount rate for equity investors. Investors usually use the higher discount rate to discount the future cash-flows as equities are much riskier.
Bonds are basically risk free. Governments may get money to pay its bond-holders by rising the taxes or printing more money. Companies cannot do that.
Side Notes:
Country Risk Premium (CRP) is the function to show the historic overall market return.
This number will indicate what is the expected return from the country’s stock market based on historic performance. we may expect a return of 10.365% from the U.S. stock market.
Market risk premium = market return - 10 year bond yield = 10.365 % - 2.931 % = 7.434 %
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10-year old bond yield value or RF Rate is displayed in both WB and CRP functions.
Both functions CRP and WACC use the US Generic Govt 10 Year Yield in the case of Facebook. You can load this as its own security using USGG10YR Index. The slight difference is that in CRP its currently displaying the value as of 6/1/18. In WACC its using today's value intraday. If you hover over the number in both functions a little window should appear showing you the ticker.
The yield on WB is the bond's current yield, based on the ask price. The CRP function displays a customizable value that is updated on an intraday basis. which will update the other fields on the page if edited.
The image blow is a comparison on how much riskier the stock is compared to the overall market. This is called as relative volatility since you compare something.
Since Facebook is based in the US so this regression is between the daily returns of SP 500 on the x axis while the daily returns of Facebook are on the y axis. Regression is run to estimate the best line fit, which is a measurement of stock’s sensitivity to the movement of the overall market.
The lower the Beta, the less subdued stock’s reaction is to the move in SP500.
BETA calculation is based on a regression. Facebook is based in the U.S., therefore the regression is between the daily returns of an American Index, S&P 500 (x axis) and the daily returns for Facebook (y axis). The BETA is the slope of the best-fit line and will tend to move in an exaggerated way relative to the movement in the market.
The get expected risk premium for facebook’s stock we multiply the beta by the expected market return.
Market Risk Premium (Expected market return) = market return - 10 year bond yield = 10.365 % - 2.931 % = 7.434 %
Equity Risk Premium = beta * expected market return = 1.141 % * 7.434 % = 8.482194 %
The final step is to add the risk free return (10 year bond yield) and expected risk premium for Facebook to get Facebook’s cost of equity.
Facebook’s cost of equity = 2.931 % + 8.482194 % = 11.413194 % ≈ 11.4 % (The result shown by WACC function)
Trivia: