Quick Start for:
Discounting Oil and Gas Income
Basis of the Manual
Introduction
Discounting
Discounted Cash Flow Appraisal
Discount Rate Components
Using the Three Techniques
Market Surveys
Developing a Discount Rate From Sales
Weighted Average Cost of Capital
Summary
Appendix 1: Discounted Cash Flow Method (Working Interest Portion Only)
Appendix 2: Estimation of Weighted Average Cost of Capital (WACC)
Appendix 3: Standard Deviation
Appendix 4: Property Specific Risk Factors
References
Appendix 2
Estimation of Weighted Average Cost of Capital (WACC)
1. Derive the typical capital structure of a broad sample of potential purchasers as a proportion of debt and equity.

Data can be found in the 12/31/19xx issue of The Value Line Investment Survey under the headings "Petroleum (Integrated) Industry" and "Petroleum (Producing) Industry."

Outstanding Common Stock (Oil Company)
= 157,627,284 shares @ 12/31/xx

Closing Common Stock Price
= \$106.75/share

Common Stock Equity
= (157,627,284 shares) x (\$106.75/share)
= \$16,827,000,000 @ 12/31/xx

Total Debt
= \$6,791,000,000 @ 12/31/xx

Total Capital
= Debt + Equity
= \$6,791,000,000 + \$16,827,000,000
= \$23,618,000,000

Debt
= \$6,791,000,000/\$23,618,000,000
= .288 or 28.8%

Equity
= \$16,827,000,000/\$23,618,000,000
= .712 or 71.2%

The capital structure is 28.8% debt and 71.2% equity.

Repeat this procedure for each company in the sample.

2. Calculate the cost of outstanding debt

Data can be found using Standard & Poor's Bond Guide (12/19xx issue)

YTM = Yield-to-Maturity @ 12/31/19xx

 DebtInstrument Debt(MM\$) YTM(%/yr) Debt x YTM Debt A \$ 27 6.29 \$ 170 Debt B 586 8.42 4,934 Debt C 132 7.52 993 Debt D 600 7.84 4,704 Debt E 265 4.95 1,312 Debt F 100 8.65 865 Debt G 300 7.87 2,361 Debt H 450 8.28 3,726 Debt I 123 8.70 1,070 Debt J 224 8.78 1,967 Debt K 300 8.29 2,487 Debt L 500 8.38 4,190 \$ 3,607 \$ 28,779

Sum of Debt
= Debt (MM\$) x YTM
= \$28,779 MM

Cost of Debt
= Sum of Debt (MM\$) / Debt (MM\$)
= (\$28,779 MM) / (\$3,607 MM)
= 7.98 %/year

Repeat this procedure for each company in the sample.

3. Calculate the cost of equity

Use the Capital Asset Pricing Model (CAPM) equation:

K = Rfc + B(Rm - Rfh)

where:

 K = cost of equity (after tax), %/year Rfc = current risk-free rate, %/yr, can be found in the Federal Reserve Statistical Release (January of current year) Rfh = historic market return on long-term government bonds, %/year, can be found in Ibbotson & Associates: Stocks, Bonds, Bills and Inflation Rm = historic market return on equities, %/year, can be found in Ibbotson & Associates: Stocks, Bonds, Bills and Inflation B = beta coefficient, can be found in The Value Line Investment Survey, 4th Qtr, 19xx Given: Rfc = 5.1%/year Rfh = 5.5%/year Rm = 12.4%/year B = .80
 K = Rfc + B(Rm - Rfh) = 5.1 + .8(12.4-5.5) = 10.6 %/year
 K (pre-tax) = 10.6/(1 - .34) Cost of equity = 16.1 %/year

Repeat this procedure for each company in the sample.

4. Calculate a typical weighted average cost of capital by plugging the mean (or other measure of central tendency) cost of debt, cost of equity and capital structure from the sample companies into the following formula:

 WACC = ((cost of debt) x (% debt)) + ((cost of equity) x (% equity)) = (7.98 x .288) + (16.1 x .712) = 13.8 %/year