Sample Business Studies Paper on WACC, Payout Ratio, and Future Prospects for BHP Group

  1. Computing BHP’s WACC

The Weighted Average Cost of Capital (WACC) refers to the average expected rate that a firm is expected to pay its security holders for financing its assets. As the firm’s average cost of capital, it uses weights to measure the burden of a firm’s sources of funds both from Debt and equity proportionately. WACC is a vital finance aspect as it allows investors and managers to gauge whether projects meet and exceed the cost of invested capital. If the project’s returns are inferior to the firm’s expected WACC, then the project should be discarded as the cost of handling the projects falls below the firm’s price of capital. Although the method uses some assumptions, it is a quick enabler in making prompt decisions.

The Weighted Average Cost of Capital (WACC) is computed using the following formula:

 

BHP’s Group’s market capitalization from Yahoo Finance is $130.233 billion

BHP’s book value of Debt as indicated by the latest financial year (2020) was $52.537 billion

The corporate tax rate in Australia is 27.5%

The cost of Debt is computed using the latest annual report by comparing the yearly interest expense with the Debt’s book value as follows:

Annual interest (2020) is $881,000,000

Book value of Debt (2020) $52,537,000,000

Cost of Equity

Using CAPM, the cost of equity can be computed from the following formula:

 

Using the 10-Year Treasury Constant Maturity Rate as the Risk-Free Rate, Trading Economics (2020) estimates the Risk-free rate at 0.87%

The Asset Beta, which represents its volatility from Yahoo Finance, is 0.98. A beta greater than one indicates that a firm’s stock is more volatile than the market, while below one shows that the stock is not as volatile as the market. BHP’s beta thus has lower volatility than the market.

The expected market return-risk-free return rate, also known as the market premium, has been held at 6%. It represents the additional return that an investor expects to receive over holding a risky portfolio rather than risk-free assets.

Therefore, the cost of equity is

Applying the WACC variables to the formula:

 

It indicates that BHP Group pays 5.16 cents for every dollar extended to it as a finance form. Any project presented to the firm should have a higher than 5.16% rate of return to justify taking finances from the sources it uses.

 

  1. Assuming that BHP had no debt

If BHP had no debt, and all other variables remained constant, then the following would ensue:

But now, debt=0 and the cost of debt=0

BHP’s Group’s market capitalization from Yahoo Finance is $130.233 billion

Assuming BHP’s book value of Debt is 0

The corporate tax rate in Australia is 27.5%

The cost of Debt is computed using the latest annual report by comparing the yearly interest expense with the Debt’s book value as follows:

Annual interest (2020) is $0

Book value of Debt (2020) $0

Cost of Equity

Using CAPM, the cost of equity can be computed from the following formula:

 

Using the 10-Year Treasury Constant Maturity Rate as the Risk-Free Rate, Trading Economics (2020) estimates the Risk-free rate at 0.87%

The Asset Beta, which represents its volatility from Yahoo Finance, is 0.98

The expected market return-risk-free return rate is also known as the market premium, has been held at 6%.

Therefore, the cost of equity is

 

From the above computations, the WACC for BHP was 5.16% when Debt was included but increased to 6.75% when excluding Debt and debt costs. It indicates that while the average cost of a dollar of finance with Debt was 5.16 cents, the average cost without Debt would be higher to 6.75 cents for every dollar of finance. The findings align with the assertion that equity financing is more expensive than debt financing, given the investor’s risk and the flexibility accorded. Debt financing is not as risky to the lender as equity finance is risky to the investor. Applying the findings, WACC is an average figure that includes Debt and equity finances’ weights, inferring that it lowers the cost of equity financing, which is always higher due to its risk. Removing the lower debt-financing value leaves equity financing more elevated than the average cost of capital. The debt weight reduces the weight of capital funds acquired from finance sources.

Adjusting for Credit Risk

  1. BHP Group’s Credit Rating

According to Moody’s credit rating, BHP Group has a rating of A2 on long-term ratings indicating that it has a strong capacity and ability to handle its financial commitments. However, the rating also notes that despite the strong position, the firm may be susceptible to adverse impacts on the business as occasioned by economic and other conditions relied on the obligor.

  1. Credit Spreads
  2. Revise the Cost of Debt and WACC for your company using the credit spread from iTraxx

The awareness of credit spreads may also be used to derive the Cost of Debt for a firm. The credit spread indicates the credit risk that s associated with a company. It can compute the cost of Debt using the following formula:

 

Risk-free rate 0.87%

Credit spread for B2 rated bonds (Theoretical Spread) 136.18

Tax rate =27.5%

 

  1. Presenting BHP’s Estimated WACC to the CFO

As noted above, BHP Group has been rated B2 by Moody’s, indicating that it has strong potential in honoring commitments under stable conditions (Moody’s, 2020). However, unforeseen events and economic or environmental upheavals may disrupt the firm’s operations and its ability to honor its commitments to obligations. Presenting the information to the CFO is critical, considering that the use of the credit spread raises the firm’s cost of Debt and, overall, raises the cost of capital. The increased cost of capital also means that the firm’s expenses increase while the net profits reduce.

  1. Investment and Financing
$ in Billions 2016 2017 2018 2019 2020
Capital Expenditures (PPE) 9.55 4.9 6.43 8.74 10.29
Outstanding PPEs 110.49 103.08 88.74 94.65 102.02

The firm’s capital expenditure in fixed properties has varied over the period, as indicated in its cash flow statement. In 2016, the firm spent $9.55 billion, which only reduced in 2017 when the firm spent $4.9 billion. However, in 2018, the firm increased its spending to $6.43 billion, then expanded its spending to $8.74 in 2019, which later rose to $10.29 billion in 2020. However, despite the notable increments in expenditures for the PPEs, the outstanding net value of the PPEs on the firm’s balance sheet has decreased considerably from $110.49 billion to $103.08 billion, then o $88.74 billion in 2018. The firm then noted a rise to $94.65 billion in 2019 and then increased to $102.02 billion. The outstanding net value coincides with the spending in the PPEs, although the notable decreases can be attributed to depreciation while other portions may have been written down.

  1. PPE Investment Vs. External Financing

Th investment in PPE and external financing have no linear relationship for BHP Group. The firm only acquired $6.33 billion for the last five years and has spent an extended period repaying the Debt. In 2017, it repaid $7.29 billion Debt; in 2018, it repaid $5 billion Debt, while in 2019, it repaid $3.52 billion, and $2.52 billion in 2020. Despite the repayments, the firm noted increases in the PPEs, indicating that the firm does not rely on external funding to purchase fixed properties. Other sources of finances for the firm include plowing back profits and equity finances.

Payout Policy

  1. Payout Ratio

BHP maintains a payout policy that pays at least 50% on the underlying attributable profits for every reporting period. The firm’s board assesses the firm’s ability to pay additional amounts over the minimum threshold and as per the capital allocation frameworks. The firm does not have preferred dividends, but it pays out dividends in the form of cash. In 2016, the firm paid out $5.68 billion, $3.87 billion in 2017, $6.74 billion in 2018, $15.93 billion, and $10.26 billion in 2020 (Moody’s, 2020). An increasing trend is noted on the dividend payouts in line with the increased profits.

2016 2017 2018 2019 2020
Cash Dividends Paid – Total (5.68B) (3.87B) (6.74B) (15.93B) (10.26B)
Common Dividends (5.68B) (3.87B) (6.74B) (15.93B) (10.26B)

Sourced from Market Watch (2020)

The above cash dividends paid can then be compared to the net profits/loss generated as follows to confirm that the firm pays dividends above 50% except in 2017, when the payout was 45.80%.

2016 2017 2018 2019 2020
Cash dividends 5.68 3.87 6.74 15.93 10.26
Net profits/Loss 8.77 8.45 8.58 12.09 11.87
Proportion 64.77% 45.80% 78.55% 131.76% 86.44%

BHP Group also notes pays out a repurchase model, as pointed out from the firm’s cash flows statement. It repurchased common stock for the five years from 2016. In 2016, it repurchased $145.67 million; in 2017, it repurchased shares worth $143.21 million; in 2018, it repurchased shares worth $220.69 million; in 2019, it repurchased $7.56 billion, while in 2020, the firm repurchased shares worth $213.31 million.

  1. Payout Policy Inference

BHP Group’s payout policy asserts that the firm pays out at least 50% of the net incomes generated and engages in share buybacks to boost its stock value and improve its financial position. The message sent across is that the firm has enough cash on hand and is on an upswing trend. Share repurchases offer an effective and efficient way for a firm to distribute its incomes to shareholders and improve its market value. Although the firm’s performance is likely to be impacted by current economic downturns, the trends may also yield favorable opportunities. It is expected to pay dividends even under uncertainty, and the demand for commodities is likely to decrease (BHP Outlook, 2020). However, in the long term, the firm expects the rising standards of living and the population growth to drive demand for metals, energy, and fertilizers and improve the firm’s value. The firm portrays a strong performance in the long term and assures the shareholders that its value is set to improve even under the adversities, and it expects to pay dividends.

 

References

Market Watch (2020). BHP Group Ltd (ADR). Retrieved from https://www.marketwatch.com/investing/stock/bhp/financials/cash-flow

E-Finance (n.d). Evaluating New Projects with Weighted Average Cost of Capital (WACC). Retrieved from https://efinancemanagement.com/investment-decisions/evaluating-new-projects-with-weighted-average-cost-of-capital-wacc#:~:text=Moreover%2C%20the%20advantages%20of%20using,of%20evaluation%20of%20new%20projects.

Moody’s Investor Service (2020). Rating Symbols and Definitions. Retrieved from https://www.moodys.com/sites/products/AboutMoodysRatingsAttachments/MoodysRatingSymbolsandDefinitions.pdf

Trading Economics (2020). Australia Government Bond 10Y. Retrieved from https://tradingeconomics.com/australia/government-bond-yield#:~:text=The%20Australia%20Government%20Bond%2010Y%20is%20expected%20to%20trade%20at,macro%20models%20and%20analysts%20expectations.

Yahoo Finance (2020). BHP Group (BHP). Retrieved from https://au.finance.yahoo.com/quote/BHP?p=BHP