Adjustments in WACC

6 Key excerpts on "Adjustments in WACC"

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  eBook - ePub

  Corporate Value Creation

  An Operations Framework for Nonfinancial Managers

  • Lawrence C. Karlson(Author)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  By definition the Weighted Average Cost of Capital is the blended cost of capital to the company for a given capital structure that reflects the risk-adjusted returns required by lenders and equity holders. Using the WACC as a discount rate for a stream of certain cash flows makes sure that as a minimum, the cash flow stream will be burdened with a discount rate that represents the combined financial expectations of all of the debt and equity stakeholders.

  The point made in the preceding paragraph should not be glossed over. Each project or investment has its own risk characteristics. A project that simply involves increasing production of an existing product is probably well understood and since it constitutes an expansion of existing business using the company's WACC as a hurdle rate is probably appropriate. Putting a new product into production or buying a company is a different matter. In both of these cases there are numerous assumptions and unknowns and therefore the WACC has to be adjusted to reflect the additional risk. Adjusting the Weighted Average Cost of Capital to reflect additional risk is a topic of its own and will be covered in a subsequent chapter.

  The Weighted Average Cost of Capital concept has numerous applications. Some of the more common uses are:

  • Establishing a hurdle rate for internal projects that have a risk profile that is the same as the company's existing business
  • It is also applicable in those cases where a company needs to calculate the maximum price it should pay for a stream of cash flows that are perceived to involve the same amount of risk as that imbedded in the WACC
  • Establishing a starting point from which it is possible to logically develop a hurdle rate for projects, investments, and so on that involve different risk profiles
  • Establishing a reference point from which to judge the impact that various projects could have on the value of the firm

  Using the Weighted Average Cost of Capital as a reference point has several implications. Taken as a whole, cash flows from projects or investments must provide funds that will pay interest on debt, repay debt in accordance with the debt amortization schedule, provide for any dividends for shareholders the board may declare, and provide cash to reinvest in the business. In general, returns on projects or investments fall into three categories.

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  eBook - ePub

  The Essentials of Financial Modeling in Excel

  A Concise Guide to Concepts and Methods

  • Michael Rees(Author)
  • 2023(Publication Date)
  • Wiley

    (Publisher)

  In the simplest (or “reference”) case(s), we assume that the financing mix is only equity and debt and take only the corporate tax rate into account. The other factors are ignored or considered irrelevant. In this case, the overall cost of capital is known as the weighted average cost of capital (WACC). It reflects the amount of each type of financing (using market values, and assuming that the optimal financing structure is used).

  The WACC can be expressed as:

  The WACC is in principle a pre‐tax figure. However, often a post‐tax figure is required, and is defined as:

  This can also be written as:

  (again, the symbols are self‐explanatory). To avoid confusion, we will refer to the “pre‐tax WACC” and the “post‐tax WACC” where relevant in this text, and to WACC when the concepts discussed apply to both.

  In practice, the WACC is not directly observable, and one may wish to estimate it by building it up from its components, which may have some observable aspects to them (e.g. the cost of debt, equity prices, and taxes). However, when doing so, one cannot simply “fix” a cost of equity and a cost of debt, and then use a weighted average formula to calculate the WACC. This is because the cost of equity changes according to the leverage, as discussed in the next Section.

  16.6 MODIGLIANI‐MILLER AND LEVERAGE ADJUSTMENTS

  An important concept that was developed by Modigliani and Miller (MM) is that – in idealized circumstances (essentially perfect markets with no costs associated with financial distress, and no taxes) – the value of the operations of a business does not depend on the split between debt and equity on the funding side, but rather only on the business operations (i.e. on operational cash flows).

  Therefore, for any debt/equity mix, the pre‐tax WACC is constant. Further, it must equal the cost of equity for an unlevered business (since this is simply the case in which there is no debt in the mix). Since the cost of debt is constant (as debt levels vary), the cost of equity must adjust so that the pre‐tax WACC stays constant. Using the formula in the last section, the cost of unlevered equity is therefore given by:

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  eBook - ePub

  The Capital Budgeting Decision

  Economic Analysis of Investment Projects

  • Harold Bierman, Jr., Seymour Smidt(Authors)
  • 2012(Publication Date)
  • Routledge

    (Publisher)

  When capital budgeting with time discounting was first introduced in the business finance literature in the early 1950s, the common recommendation was that an investment was acceptable if the net present value was positive using the firm’s weighted average cost of capital (WACC) as the discount rate (or, equivalently, if the investment’s internal rate of return was greater than the firm’s weighted average cost of capital). Even today, more business firms are using the firm’s weighted average cost of capital as the hurdle rate than any other required return. This utilization makes the cost of capital calculation of great importance. Although we do not endorse the general use of the firm’s cost of capital in the capital budgeting process as a single hurdle rate, it nevertheless is used; thus we should compute it in a reasonable manner. The same general approach can be used to compute a project’s cost of capital or a cash flow component’s cost of capital.

  There is also the question of how the asset’s value is affected by the financial mix decision. The following theories deserve consideration.

  1. The value of a firm and the consequent wealth position of the stockholders is not affected by the type of financing.
  2. There is an optimum capital structure and the utilization of this structure will maximize the value of the firm.
  3. Given the present corporate tax laws, a firm should use as much debt as possible to maximize its value and the wealth position of its stockholders.
  4. The use of debt offers a tax advantage but it also increases the expected costs of financial distress.
  5. Given the presence of personal taxes as well as corporate taxes, common stock may have tax advantages compared to debt by means of tax deferral as well as preferential treatment of capital gains and dividends.

  In this chapter we examine and evaluate each of these theories and the role the weighted average cost of capital plays in the capital structure and capital budgeting decisions. The key symbols to be used are:

  k0 =	the weighted average after-tax cost of capital
  ki =	the before-tax average cost of debt, ki (1−tc ) the after-tax cost of debt
  ke =	the after-tax average cost of equity capital
  B =	the market value of the debt in the capital structure
  S =	the market value of the stock equity in the capital structure
  V =	the total market value of the firm: Vu is the value of an unlevered firm; VL is the value of a levered firm
  tc =	the corporate tax rate.

  Definition

  The weighted average cost of capital (k0 or WACC) is defined as the sum of the weighted costs of debt (ki ) and equity capital (ke ), where the weights are the relative importance of each in the firm’s capital structure and the ki and ke

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  eBook - ePub

  The Fundamental Principles of Finance

  • Robert Irons(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  8  Capital Structure and the WACC

  Capital structure refers to the mix of debt and equity the firm uses to fund its assets. There are some large firms that use little or no long-term debt, like Facebook (with zero long-term debt 2013–2017), and others that make much more use of debt, like Tesla (with only 15% of their assets funded by equity in 2017). The different sources of funds have different costs and different levels of risk, and firms typically use the mix of debt, preferred equity and common equity that minimizes their weighted average cost of capital (WACC)—the average cost from all sources of funds, weighted according to how much of each source the firm uses to finance its operations. The overall cost the firm pays for the money it raises will be a function of the amount of money raised via each source (the weights of each source in the capital structure) and the required return associated with each source (the component costs of capital).

  In this chapter, we discuss the sources of funds available to the firm and the methods used to determine the cost of funds from each of those different sources. We will review how to determine the weights for each source of capital used in the capital structure, and then put it all together to calculate the weighted average cost of capital. Since the WACC is used as the discount rate for valuing projects as well as for the CFFA model for valuing the firm, this subject is closely tied to all three of the fundamental principles.

  The Fundamental Principles in Action

  FP1 says that the value of an asset is the present value of the cash flows the asset is expected to produce. For production projects, as well as for the free cash flow model for valuing the firm, the present value is calculated using the WACC as the discount rate. FP2 states that risk and return are directly related, and so riskier assets require higher returns. In the capital budgeting process, projects of higher than average risk are discounted using the WACC increased to adjust for risk. Since the WACC is the weighted average return to the firm’s investors, this method assumes that investors will be compensated for taking on higher than average risk with a higher than average return, which is consistent with both PR1 and PR3. FP3 indicates the negative relationship between yield and value; adjusting the WACC up for above-average risk projects will cause the present value of the project’s cash flows (and therefore its value) to decrease.

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  eBook - ePub

  Finance for IT Decision Makers

  A practical handbook

  • Michael Blackstaff(Author)
  • 2012(Publication Date)
  • BCS, The Chartered Institute for IT

    (Publisher)

  Lenders to a company will usually be prepared to accept a lower return than shareholders, because lending is less risky. There are two reasons for this. First, payment of interest on a loan is compulsory, while dividends are not. Second, lenders have more security than do shareholders. They have a higher priority for getting paid when a company is wound up, so they stand more chance of getting their money back should it fail.

  WEIGHTED AVERAGE COST OF CAPITAL (WACC)

  So, what is a particular company’s cost of capital? It is a combination of its cost of equity and its cost of debt. If there were equal quantities of equity and debt, then the cost of capital would be the average of the two. Because the respective quantities are usually unequal, a weighted average is required. So, a company’s cost of capital is the weighted average of its costs of equity and debt. The following example illustrates the calculation and introduces the effect of tax.

  Let us assume for simplicity that a company has CU3 million of equity and CU1 million of debt. The total capital employed is therefore CU4 million. Suppose that the ‘cost of equity’ is 12 per cent per annum and the cost of debt eight per cent. What is the company’s current ‘cost of capital’? The calculation is as follows:

  (3 / 4 × 12) + (1 / 4 × 8) = 9 + 2 = 11%

  Therefore the basis of the discount rate used by this particular company in discounted cash flow calculations would be 11 per cent, but only if the company ignores tax in such calculations. Dividends are paid out of already-taxed profit. Interest on business loans, however, unlike interest on personal loans, is usually an expense deductible in arriving at profit. Therefore, the true cost of loan interest is not its gross cost but its net-of-tax cost. If the tax rate paid by the above company is, for example, 30 per cent, then the net-of-tax cost is not eight per cent but 5.6 per cent. To arrive at the after-tax cost of capital, the above calculation would be restated as follows:

  (3 / 4 × 12) + (1 / 4 × 5.6) = 9 + 1.4 = 10.4%

  Not all organisations are taxable and not all businesses take tax into account in investment evaluations. However, many do, and that is why a chapter on tax (Chapter 7

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  eBook - ePub

  Outperform with Expectations-Based Management

  A State-of-the-Art Approach to Creating and Enhancing Shareholder Value

  • Tom Copeland, Aaron Dolgoff(Authors)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  When the WACC is high, near-term results become more important to value, and therefore there is a relatively greater bias toward harvesting decisions. Lower WACCs encourage a relatively longer-term outlook, biasing toward making investment decisions regardless of short-term impact. Third, we noted that the cost of capital is linked to expected future growth—and that management’s degree of emphasis on short-term versus long-term expectations and performance will vary with different combinations of growth and discount rates. All else equal, a faster growth firm will require greater emphasis on long-term expectations. The chapter continued with a reminder that the cost of capital is really a business-specific factor that may vary across various lines of business within a company. We have seen dozens of firms treat all businesses the same by using a corporate WACC, but such an approach risks obscuring important drivers of value that can differ by business. Knowing each business’s WACC —or at least its WACC relative to other businesses in the corporation—is an essential part of a properly structured EBM system. Finally, we noted that expectations play a role in managers’ financing decisions, given the close connection between operating and investment risks and the factors driving debt and risk-management decisions. 1 Note that where real options methods are used to value new projects, the analysis starts with the traditional NPV of the project (without flexibility). This, of course, discounts cash flows at the WACC. 2 Duration may be defined as the percent change in the present value of a financial instrument with respect to a percentage change in interest rates, roughly equivalent to the weighted average timing of expected cash flows measured in present value terms. 3 A U.S. Treasury strip is a security created by “stripping” the coupon payments out from principal repayment on U.S. Treasury securities

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