Question

1. Why are there so many different adjustments and inputs used by industry professionals when calculating the WACC? Provide at three examples and explain.

Answer 1

Defination of WACC?

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.

is an important input in capital budgeting and business valuation.  It is the discount rate used to find out the present value of cash flows in the net present value technique. It is the hurdle rate to which the internal rate of returns of different projects are compared to decide whether the projects are feasible. It is also used in the free cash flow valuation model to discount the free cash flow to firm to find a company's intrinsic value.

A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together.

WACC formula and calculation

WACC=VE​∗Re+VD​∗Rd∗(1−Tc)

where:Re = Cost of equity

Rd = Cost of debt

E = Market value of the firm’s equity

D = Market value of the firm’s debt

V = E + D = Total market value of the firm’s financing

E/V = Percentage of financing that is equity

D/V = Percentage of financing that is debt

Tc = Corporate tax rate​

To calculate WACC the analyst will multiply the cost of each capital component by its proportional weight. The sum of these results is, in turn, multiplied by the corporate tax rate, or 1. Apply the following values to the formula listed above.

Bullet points

1) Calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

2) Incorporates all sources of a company’s capital—including common stock, preferred stock, bonds, and any other long-term debt.

3) Can be used as a hurdle rate against which companies and investors can gauge ROIC performance.

4) WACC is commonly used as the discount rate for future cash flows in DCF analyses.

Cost of equity (Re) can be a bit tricky to calculate since share capital does not technically have an explicit value. When companies pay a debt, the amount they pay has a predetermined associated interest rate that debt depends on the size and duration of the debt, though the value is relatively fixed. On the other hand, unlike debt, equity has no concrete price that the company must pay. Yet that doesn't mean there is no cost of equity

Since shareholders will expect to receive a certain return on their investments in a company, the equity holders' required rate of return is a cost from the company's perspective, because if the company fails to deliver this expected return, shareholders will simply sell off their shares, which leads to a decrease in share price and in the company’s value. The cost of equity, then, is essentially the amount that a company must spend in order to maintain a share price that will satisfy its investors.

A firm's WACC is the overall required return for a firm. Because of this, company directors will often use WACC internally in order to make decisions, like determining the economic feasibility of mergers and other expansionary opportunities. WACC is the discount rate that should be used for cash flows with the risk that is similar to that of the overall firm.

The WACC formula seems easier to calculate than it really is. Because certain elements of the formula, like the cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, while WACC can often help lend valuable insight into a company, one should always use it along with other metrics when determining whether or not to invest in a company.

There are also many other options to find the return from capital Invested other than WACC i.e RRR (Rate of Return)

Securities analysts frequently use WACC when assessing the value of investments and when determining which ones to pursue. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future cash flows in order to derive a business's net present value. WACC may also be used as a hurdle rate against which companies and investors can gauge return on invested capital (ROIC) performance. WACC is also essential in order to perform economic value-added (EVA) calculations.

Investors may often use WACC as an indicator of whether or not an investment is worth pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company yields returns for its investors. To determine an investor’s personal returns on an investment in a company, simply subtract the WACC from the company’s returns percentage.

WACC is often used by calculating Equity , Debt and preferred Stock

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which equates rates of return to volatility (risk vs reward). Below is the formula for the cost of equity:

Re = Rf + β × (Rm − Rf)

Where:

Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield)
β = equity beta (levered)
Rm = annual return of the market

The cost of equity is an implied cost or an opportunity cost of capital. It is the rate of return shareholders require, in theory, in order to compensate them for the risk of investing in the stock

The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost. Thus, it is used as a hurdle rate by companies.

A company will commonly use its WACC as a hurdle rate for evaluating mergers and acquisitions (M&A), as well as for financial modeling of internal investments. If an investment opportunity has a lower Internal Rate of Return (IRR) than its WACC, it should buy back its own shares or pay out a dividend instead of investing in the project.

Many professionals and analysts in corporate finance use the weighted average cost of capital in their day-to-day jobs. Some of the main careers that use WACC in their regular financial analysis include:

• Investment banking
• Equity research
• Corporate development
• Private equity

Also there are many different factors that are effecting WACC,

• Economic Conditions. When a bank provides a company with easy loans to alleviate stability, the company's debts are reduced subsequently. ...
• Capital Structure. The value of debt to equity ratio also has an impact on your business's weighted average cost of capital. ...
• Dividend Policy. ...
• New Funds Received. ..
• Factors the Firm Cannot. Control.
• Interest rates in the. economy. ...
• If interest in the economy rise, the. cost of debt increases.
• General level of stock prices. Ex: ...
• If stock prices in general decline, its cost of equity will rise. ...
• When tax rates increases, cost. ....
• By changing its capital.
• It assumes that there would be no change in the capital structure which isn’t possible for all over the years and if there is any need to source more funds.
• It also assumes that there would be no change in the risk profile. As a result of faulty assumption, there is a chance of accepting bad projects and rejecting good projects.

Example

1) Suppose that a company yields returns of 20% and has a WACC of 11%. This means the company is yielding 9% returns on every dollar the company invests. In other words, for each dollar spent, the company is creating nine cents of value. On the other hand, if the company's return is less than WACC, the company is losing value. If a company has returns of 11% and a WACC of 17%, the company is losing six cents for every dollar spent, indicating that potential investors would be best off putting their money elsewhere.

As a real-life example, consider (ABC LLC). The WACC of ABC LLC is 4.2%. That number is found by doing a number of calculations. First, we must find the financing structure of ABC LTD to calculate V, which is the total market value of the company’s financing. For ABC LTD, to find the market value of its debt we use the book value, which includes long-term debt and long-term lease and financial obligations.

As of the end of its most recent quarter (Oct. 31, 2018), its book value of debt was $50 billion. As of Feb. 5, 2019, its market cap (or equity value) is $276.7 billion. Thus, V is $326.7 billion, or $50 billion + $276.7 billion. ABC LTD finances operations with 85% equity (E / V, or $276.7 billion / $326.7 billion) and 15% debt (D / V, or $50 billion / $326.7 billion).

To find the cost of equity (Re) one can use the capital asset pricing model (CAPM). This model uses a company’s beta, the risk-free rate and expected return of the market to determine the cost of equity. The formula is risk-free rate + beta * (market return - risk-free rate). The 10-year Treasury rate can be used as the risk-free rate and the expected market return is generally estimated to be 7%. Thus, ABC LTD’s cost of equity is 2.7% + 0.37 * (7% - 2.7%), or 4.3%.

The cost of debt is calculated by dividing the company’s interest expense by its debt load. In ABC LTD’s case, its recent fiscal year interest expense is $2.33 billion. Thus, its cost of debt is 4.7%, or $2.33 billion / $50 billion. The tax rate can be calculated by dividing the income tax expense by income before taxes. In ABC LTD’s case, it lays out the company’s tax rate in the annual report, said to be 30% for the last fiscal year.

2) XYZ. went public by issuing 1 million shares of common stock @ $25 per share. The shares are currently trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta coefficient of 1.2.

During last year, it issued 50,000 bonds of $1,000 par paying 10% coupon annually maturing in 20 years. The bonds are currently trading at $950.

If the tax rate is 30%, calculate the weighted average cost of capital.

Solution

First we need to calculate the proportion of equity and debt in XYZ, Inc. capital structure.

Calculating Capital Structure Weights

Current Market Value of Equity
= 1,000,000 × $30
= $30,000,000

Current Market Value of Debt
= 50,000 × $950
= $47,500,000

Total Market Value of Debt and Equity
= $77,500,000

Weight of Equity
= $30,000,000 ÷ $77,500,000
= 38.71%

Weight of Debt
= $47,500,000 ÷ $77,500,000
= 61.29%, or

Weight of Debt
= 100% minus cost of equity
= 100% − 38.71%
= 61.29%

Now, we need estimates for cost of equity and after-tax cost of debt.

Estimating Cost of Equity

We can estimate cost of equity using either the dividend discount model (DDM) or capital asset pricing model (CAPM).

Cost of equity (DDM)
= Expected Dividend in 1 year ÷ Current Stock Price + Growth Rate

Cost of equity (CAPM)
= Risk Free Rate + Beta Coefficient × Market Risk Premium

In the current example, the data available allow us to use only CAPM to calculate cost of equity.

Cost of Equity
= Risk Free Rate + Beta × Market Risk Premium
= 4% + 1.2 × 8%
= 13.6%

Estimating Cost of Debt

Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find that yield to maturity is 10.61%. It is calculated using hit and trial method. We can also estimate it using MS Excel RATE function.

For inclusion in WACC, we need after-tax cost of debt, which is 7.427% [= 10.61% × (1 − 30%)].

Calculating WACC

Having all the necessary inputs, we can plug the values in the WACC formula to get an estimate of 9.82%.

WACC
= 38.71% × 13.6% + 61.29% × 7.427%
= 9.8166%

It is called weighted average cost of capital because as you see the cost of different components is weighted according to their proportion in the capital structure and then summed up.

WACC represents the average risk faced by the organization. It would require an upward adjustment if it has to be used to calculate NPV of projects which are riskier than the company's average projects and a downward adjustment in case of less risky projects. Further, WACC is after all an estimation. Further, different models for calculation of cost of equity may yield different values.

3)

Particulars	Company A	Company B
Market Value of Equity (E)	300000	500000
Market Value of Debt (D)	200000	100000
Cost of Equity (Re)	4%	5%
Cost of Debt (Rd)	6%	7%
Tax Rate (Tax)	35%	35%

We need to calculate WACC (Weighted Average Cost of Capital) for both of these companies.

Let’s look at the WACC formula first –

WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax)

Now, we will put the information for Company A,

weighted average cost of capital formula of Company A = 3/5 * 0.04 + 2/5 * 0.06 * 0.65 = 0.0396 = 3.96%.

weighted average cost of capital formula of Company B = 5/6 * 0.05 + 1/6 * 0.07 * 0.65 = 0.049 = 4.9%.

Now we can say that Company A has a lesser cost of capital (WACC) than Company B. Depending on the return both of these companies make at the end of the period, we would be able to understand whether as investors we should invest into these companies or not.

Conculsion

WACC is very useful if we can deal with the above limitations. It is exhaustively used to find the DCF valuation of the company. However, WACC is a bit complex and needs a financial understanding to calculate the Weighted Average Cost of Capital accurately. Only depending on WACC to decide whether to invest in a company or not is a faulty idea. The investors should also check out other valuation ratios to take the final decision.