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 hasnt 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 Moodys. 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 Lears debt + Cost of Lears 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.

Cost of Lears 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 Lears 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 Lears equity

Cost of equity is calculated as:

rE,t rrf,t

rm rrf
Market Risk Premium

As assumed in calculation of debt cost, risk free rate for 10 years time horizon is 3.61%. The beta for the
Lears stock is calculated by using regression analysis of the weekly returns of NYSE composite index and
Lears 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 Lears 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%

Appendix
Regression output for calculation of Beta
SUMMARY
OUTPUT

Regression Statistics
Multiple R

0.698937847

R Square
Adjusted R
Square
Standard
Error
Observatio
ns

0.488514115
0.485192778
0.023964556
156

ANOVA
df

SS

Regression
Residual
Total

1 0.084470087

0.08447009

154 0.088442188
155 0.172912275

0.0005743

Coefficients
Intercept
X Variable
1

MS

Standard
Error
0.002942323 0.001931585
1.463610792 0.120682281

t Stat
1.52326891
12.1278018

Significance
F
147.083577 3.4702E-24

P-value
0.12974229
3.4702E-24

Lower 95%
-0.0008735
1.22520439

Upper 95%
0.00675815
1.70201719

Lower
95.0%
-0.0008735
1.22520439

Upper
95.0%
0.00675815
1.70201719

Beta

Cost of Debt

Alternate calculation:

Risk free rate assumption

Synthetic credit spread

3.61%
2.25%

For Baa3 rating

Years (Time Horizon)

1
2
3

Risk free rate

0.30%
0.79%
1.36%

Cost of debt
2.55%
3.04%
3.61%

5
10

2.34%
3.61%

4.59%
5.86%

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 of

debt (tax rate
30%)

6.04%

Cost of equity
Beta for Lear

1.463610792

Market risk premium

Years
(Time
Horizon)
1
2
3
5
10

Risk
rate
0.30%
0.79%
1.36%
2.34%
3.61%

(Coefficient of X in regression output)

6.50% (Estimated equity risk premium)

free

Cost
equity
9.81%
10.30%
10.87%
11.85%
13.12%

of

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
equity

of

WACC

2.55%

9.81%

8.31%

3.04%

10.30%

8.80%

3.61%

10.87%

9.37%

4.59%

11.85%

10.35%

10

5.86%

13.12%

11.62%