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Unformatted text preview: WACC: Practical Guide for Strategic DecisionMaking  Part 1: Is Estimating the WACC Like
Interpreting a Piece of Art?
This sevenpart series, authored by Zanders consultants, provides CFOs and
corporate treasurers with a better understanding of the weighted average cost
of capital (WACC), which is recognized as one of the most critical parameters
in strategic decisionmaking. The series highlights strategies to optimize the
capital structure and maximize shareholder value.
Laurens Tijdhof  Senior Consultant, Zanders, Treasury & Finance Solutions
This article, the first in the series, describes how
to estimate the weighted average cost of capital
(WACC) and the issues that need to be considered
when doing so.
If companies were entirely financed with equity,
there would be little difficulty in determining its cost
of capital: it would be the expected return required
by shareholders. Most companies, however, are
not wholly financed with equity. They tend to issue
a variety of financing instruments, including debt,
equity and hybrids. Due to this financing mix,
companies usually calculate a weighted average cost
of capital (WACC).
Overview of WACC Estimation
The WACC is recognized as one of the most critical
parameters in strategic decisionmaking. It is
relevant for business valuation, capital budgeting,
feasibility studies and corporate finance decisions.
When estimating the WACC for a company, there is a
clear tradeoff between theoretical purity and actual
circumstances faced by a company. The decision in
this context should reflect the actual environment in
which a company operates. In general, the WACC is
estimated using the following equation: D: Market value of interestbearing debt
E: Market value of common equity
H: Market value of hybrid capital
RD: Cost of interestbearing debt
RE: Cost of common equity Reprinted from www.gtnews.com RH: Cost of hybrid capital
Ô: Corporate tax rate
The estimation of the WACC is based on several key
assumptions: • It is market driven. It is the expected rate of return that the market requires to commit capital to an
investment.
• It is a function of the investment, not the investor.
• It is forward looking, based on expected returns.
• the base against which the WACC is measured is
market value, not book value.
• It is usually measured in nominal terms, which
includes expected inflation.
• It is the link, called a discount rate, which equates
expected future returns for the life of the investment
with the present value of the investment at a given
date.
The WACC seems easier to estimate than it really
is. Just as two people will rarely interpret a piece of
art the same way, neither will two people calculate
the same WACC. Even if two people do reach the
same WACC, all the other applied judgments and
valuation methods are likely to ensure that each
has a different opinion regarding the components
that comprise the company value. Therefore, the
following sections of this article will discuss the
different WACC components in more detail. Errors
that are frequently encountered in practice will be
highlighted as well as best market practice as a guide
for estimating the WACC. Page 1 Capital Structure
The first step in developing an estimate of the WACC
is to determine the capital structure for the company
or project that is being valued. This provides the
market value weights for the WACC formula. Best
market practice is to define a target capital structure
and this is for several reasons. First, the current capital
structure may not reflect the capital structure that is
expected to prevail over the life of the business. The
second reason for using a target capital structure
is that it solves the potential problem of circularity
involved in estimating the WACC, which arises when
calculating the WACC for private companies. For
instance, we need to know market value weights
to determine the WACC but we cannot know the
market value weights without knowing what the
market value is in the first place. To develop a target
capital structure, a combination of three approaches
is suggested:
1. Estimate the current capital structure.
A capital structure can comprise three categories of
financing: interestbearing debt, common equity and
hybrid capital. The best approach for estimating the
current ‘market valuebased’ capital structure is to
identify the values of the capital structure elements
directly from their prices in the marketplace, if
available. For equity, market prices are available for
public companies, but it is more difficult to identify
the market value of equity for private companies,
business units and also for illiquid stocks. The same
applies for public debt, such as bonds, where the
market value can be identified from available market
prices. In the case of private debt, however, such as
bank loans and private placements, the current value
needs to be calculated. (For discussion about the
difficulties of calculating the market value of hybrid
capital, please refer to the third article in this series
on the WACC.) The conclusion is that estimating the
current capital structure based on market values could
be difficult when market prices are not available. The
next approach could assist in solving this difficulty,
by estimating a target capital structure based on
information from comparable companies.
2. Review the capital structure of comparable
companies.
In addition to estimating the market valuebased
capital structure currently and over time, it is useful
to review the capital structures of comparable
companies as well. There are two reasons for
this. First, comparing the capital structure of the
company with those of similar companies will help
to understand if the current estimate of the capital
structure is unusual. It is perfectly acceptable that
the company’s capital structure is different, but it
is important to understand the reasons behind this.
The second reason is a more practical one because in
some cases it is not possible to estimate the current
financing mix for the company. For privately held
companies, a marketbased estimate of the current
value of equity is not available. Reprinted from www.gtnews.com 3. Review senior management’s approach to
financing.
It is important to discuss the company’s capital
structure policy with senior management to determine
their explicit or implicit target capital structure for
the company and its businesses. This discussion
could give an explanation why a company’s capital
structure may be different from comparable
companies. For instance, is the company by
philosophy more aggressive or innovative in the use
of debt financing? Or is the current capital structure
only a temporary deviation from a more conservative
target? Often companies finance acquisitions with
debt they plan to amortize rapidly or refinance with
equity in the near future. Alternatively, there could
be a difference in the company’s cash flow or asset
intensity, which results in a target capital structure
that is fundamentally different from comparable
companies.
Corporate Tax Rate
The WACC is a calculation of the ‘after tax’ cost of
capital. The tax treatment for the different capital
components  such as interestbearing debt,
common equity and hybrid capital  is different. The
corporate tax rate in the earlier mentioned WACC
equation is applicable to debt financing because in
most countries interest expense on debt is a taxdeductible expense to a company. It is appropriate,
however, to take into consideration the fact that
several countries apply thin capitalization rules that
may limit tax deductibility of interest expenses to a
maximum leverage.
Furthermore, in some countries, expenses on hybrid
capital could be tax deductible as well. In that case
the corporate tax rate should also be applied to
hybrid financing and the WACC equation should
be changed accordingly. (For more information on
hybrid capital please refer to the third article of this
series on the WACC.)
Finally, corporate tax can also have a positive impact
on the cost of equity. An example is Belgium, which
recently introduced a system of notional interest
deduction, providing a tax deduction for the cost of
equity. This system will be further explained in the
fifth article of this series, which elaborates on the
impact of notional interest deduction on the WACC.
In other words, the calculation of the WACC for
Belgian financing structures needs to be revised.
The main conclusion is that the application of the
corporate tax rate in the WACC equation will differ
per country. As mentioned before, when estimating
the WACC for a company, there is a clear tradeoff
between theoretical purity and actual circumstances
faced by the company. Best market practice is to
reflect the actual environment in which a company
operates. Therefore the WACC equation needs to be
revised accordingly. Page 2 Cost of Interestbearing Debt
The cost of interestbearing debt can be estimated
using the following equation:
RD = RF + DRP
RD: Cost of interestbearing debt
RF: Riskfree rate
DRP: Debt risk premium
The category of interestbearing debt consists
of shortterm debt, longterm debt and leases.
Many companies have floatingrate debt, as an
original issue or artificially created by interest rate
derivatives. If floatingrate debt has no cap or floor,
then it is best market practice to use the longterm
debt interest rate. This is because the shortterm rate
will be rolled over and the geometric average of the
expected shortterm rates is equal to the longterm
rate.
The cost of debt is calculated using the marginal
cost of debt, i.e. the cost the company would incur
for additional borrowing, or refinancing its existing
interestbearing debt. This cost is a combination of
the riskfree rate and a debt risk premium. Credit
ratings are the primary determinants of the debt
risk premium. (More information on the relationship
between the WACC, shareholder value and credit
ratings can be read in the second article of this series
on the WACC.)
The riskfree rate is the theoretical rate of return
attributed to an investment with zero risk. The riskfree rate represents the interest that an investor would
expect from an absolutely riskfree investment over
a specified period of time. In theory, the riskfree rate
is the minimum return an investor should expect
for any investment. In practice, however, the riskfree rate does not technically exist, since even the
safest investments carry a very small amount of risk.
Therefore best market practice for WACC estimations
is to use the yield on a 10year government bond as
a proxy for the riskfree rate. Estimating the WACC
can be a challenging exercise, however, because a
riskfree government bond is not always available in
emerging markets. (This will be discussed further in
article seven of this series.)
The cost of debt is the yieldtomaturity on publicly
traded bonds of the company. Failing availability
of that, the rates of interest charged by banks on
recent loans to the company would also serve as a
good cost of debt. When using yieldtomaturity to
estimate the cost of debt it is important to make a
distinction between investment and noninvestment
grade debt. Investment grade debt has a credit rating
greater than or equal to BBB (Standard & Poor’s).
For investment grade debt, the risk of bankruptcy is
relatively low. Therefore, yieldtomaturity is usually
a reasonable estimate of the opportunity cost. The
coupon rate, which is the historical cost of debt, is
irrelevant for determining the current cost of debt.
Best market practice is to use the most current Reprinted from www.gtnews.com market rate on debt of equivalent risk. A reasonable
proxy for the risk of debt is a credit rating.
When dealing with debt that is less than investment
grade, pay attention to the difference between the
expected yieldtomaturity and the promised yieldtomaturity. The latter assumes that all payments
(coupon and principal) will be made as promised by
the issuer. Therefore it is necessary to compute the
expected yieldtomaturity, not the quoted, promised
yield. This can be done based on the current market
price of a lowgrade bond and estimates of its
expected default rate and value in default. If the
necessary data is not available, use the yieldtomaturity of BBBrated debt, which reduces most of
the effects of the differences between promised and
expected yields.
Leases, both capital and operating, are substitutes
for other types of debt. In many cases it is reasonable
to assume that their opportunity cost is the same
as for the company’s other longterm debt. Since
capital leases are already shown as debt on the
balance sheet, their market value can be estimated
just like other debt. Operating leases should also be
treated like other forms of debt. As a practical matter,
if operating leases are not significant, it could be
decided not to treat them as debt. They can be left
out of the capital structure and the lease payments
could be treated as an operating cost.
Cost of Common Equity
For estimating the opportunity cost of common
equity, best market practice is to use the expanded
version of the capital asset pricing model (CAPM).
The equation for the cost of equity is as follows:
RE = RF + [βL * MRP] + SRP
RE: Cost of common equity
RF: Riskfree rate
βL: Levered beta of equity
MRP: Market risk premium
SRP: Specific risk premium
The market risk premium is the extra return that
the stock market provides over the riskfree rate
to compensate for market risk. The estimate of the
historically derived market risk premium is about
5 per cent. This estimate depends on how much
history is used. Structural changes in the economy
and markets, however, suggest that more recent
data provides a better basis for predicting the
future. Therefore, best market practice is to use
data from the second half of the last century. This
is a sufficiently long period to achieve statistical
reliability, while avoiding the potentially less
relevant market returns. The historically derived
market risk premium can be benchmarked against
the implied market risk premium of today’s market
capitalization and earnings. This can be done under
different assumptions for future earnings growth
and reinvestment. Recent studies show an implied Page 3 market risk premium of 55.5 per cent, which is
comparable to the historical derived estimate.
Beta is the measurement for the systematic risk of a
company and is typically the regression coefficient
between historical dividendadjusted stock returns
and market returns. For decades, investors were
only concerned with one factor, beta, in their
portfolio selection. Beta was considered to explain
most of a portfolio’s return. This onefactor model,
otherwise known as standard CAPM, implies that
there is a linear relationship between a company’s
expected return and its corresponding beta. Beta
is not the only determinant of stock returns though
so CAPM has been expanded to include two other
key risk factors that together better explain stock
performance: market capitalization and booktomarket (BtM) value. to construct an industry beta. When constructing
the industry beta, it is important to ‘unlever’ the
company betas and then apply the leverage of the
specific company.
Best market practice is to incorporate a specific
risk premium for small caps and value stocks
when estimating the cost of equity. As mentioned
earlier, this premium may be applicable to a specific
company, based on its market capitalization and
BtM value.
Cost of Hybrid Capital
Hybrids are financial instruments that combine certain
elements of debt and equity, such as preferred equity,
convertible bonds and subordinated debt. WACC
estimations are complicated by the introduction
of hybrid capital into the capital structure. This is
most easily resolved through an effective split of the
instrument’s value into debt and equity to reflect the
true debtequity mix. (The fifth article of this series
describes how issuing hybrids can optimize the
WACC. The article outlines how hybrids are analyzed
on their impact on shareholder value, but they are
also analyzed from the perspective of treatment by
accountants/IFRS and rating agencies.)
Conclusion Recent empirical studies indicate that three risk
factors  market (beta), size (market capitalization)
and price (BtM value)  explain 96 per cent of
historical equity performance. These threefactor
models go further than CAPM to include the fact that
two particular types of stocks outperform markets
on a regular basis: small caps and value stocks (high
BtM value).
The approach to estimate beta depends on whether
the company’s equity is traded or not. Therefore the
beta of a company can be estimated in two ways. The
first and preferred solution for public companies is to
use direct estimation, based on historical returns for
the company in question. The second way is to use
indirect estimation. This solution is mainly applicable
to business units and private companies, but also
for illiquid stocks or public companies with very little
useful historical data. This estimation is based on
betas from comparable companies, which are used Reprinted from www.gtnews.com There are many ways to make errors both in estimating
the WACC and applying it in practice and this article
discussed the different WACC components in more
detail. Attention was given to some of the errors
frequently encountered in practice. Best market
practice was provided as a guide for estimating the
WACC while more practical guidance on estimation
and application of the WACC will be discussed in the
rest of the articles in this series.
Let’s return to the analogy at the beginning of this
article. Is estimating the WACC comparable to
interpreting a piece of art? Again, just as two people
will rarely interpret a piece of art the same way,
neither will two people calculate the same WACC.
The key message of this article is that both are based
on assumptions before reaching a final estimation or
interpretation. The more time you spend on defining
good assumptions for estimating the WACC, the
better the quality of business valuation, capital
budgeting and other financial decisionmaking will
be. It is like discovering the real value of art; it all
starts with a good interpretation. Page 4 Laurens Tijdhof is a senior consultant with Zanders, Treasury & Finance Solutions. He has several years of
experience in consulting and corporate treasury management. He has a broad understanding of treasury
issues, especially related to corporate financing. At Zanders, he is involved in the corporate finance practice.
The corporate finance team at Zanders offers quantitative analysis of financing structures for its clients and
is an independent advisor or arranger on debt, equity and hybrid structures.
Zanders, Treasury & Finance Solutions is a specialist in treasury management, treasury IT, corporate finance,
risk management and asset & liability management. Our field includes all activities aimed at the financing
and financial risks of a company and any future changes therein. Zanders was incorporated in 1994 and
employs approximately 50 specialised consultants to provide advice to a diverse range of companies and
government bodies, including banks, pension funds, multinational enterprises, municipalities, hospitals,
housing corporations. www.gtnews.com is the number one global information resource for senior finance and treasury professionals. Updated weekly, gtnews provides informed commentry, news and analysis from hundreds of key players throughout the
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Reprinted from www.gtnews.com Page 6 ...
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