Question

A. Make an argument for using the WACC to evaluate leasing. B. How is this consistent with other capital budgeting problems? C. How does the “sequencing problem” come into play?

Answer 1

A. Make an argument for using the WACC to evaluate leasing.

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.

WACC is the average of the costs of these types of financing, each of which is weighted by its proportionate use in a given situation. By taking a weighted average in this way, we can determine how much interest a company owes for each dollar it finances.

Debt and equity are the two components that constitute a company’s capital funding. Lenders and equity holders will expect to receive certain returns on the funds or capital they have provided. Since the cost of capital is the return that equity owners (or shareholders) and debt holders will expect, WACC indicates the return that both kinds of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC is an investor’s opportunity cost of taking on the risk of investing money in a company.

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

To help understand WACC, try to think of a company as a pool of money. Money enters the pool from two separate sources: debt and equity. Proceeds earned through business operations are not considered a third source because, after a company pays off debt, the company retains any leftover money that is not returned to shareholders (in the form of dividends) on behalf of those shareholders.

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.

B. How is this consistent with other capital budgeting problems?

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.

Calculating the cost of debt (Rd), on the other hand, is a relatively straightforward process. To determine the cost of debt, you use the market rate that a company is currently paying on its debt. If the company is paying a rate other than the market rate, you can estimate an appropriate market rate and substitute it in your calculations instead.

There are tax deductions available on interest paid, which are often to companies’ benefit. Because of this, the net cost of a company's debt is the amount of interest it is paying, minus the amount it has saved in taxes as a result of its tax-deductible interest payments. This is why the after-tax cost of debt is Rd (1 - corporate tax rate).

Limitations of WACC

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.

C. How does the “sequencing problem” come into play?

Sequencing refers to the implementation of economic reforms to revive an economy that is not working properly, specifically, sequencing is all about introducing them in the right order. When an economy malfunctions, it is not enough to simply introduce the right policies, say some economists – they need to come in the right sequence and the correct pace. Over the past couple of decades, sequencing and pace have become popular topics in development economics.

Sequencing may also refer to the interruption of a woman’s career to bear children and take care of them until they reach an age that allows her to return to the workplace.

“The sequencing of reforms refers to the order in which either macroeconomic policy actions or specific reforms are introduced.”

“Sequencing involves the order in which reforms are undertaken across sectors – for example, whether fiscal adjustment or stabilization should be a prerequisite for introducing current account liberalization or decontrolling prices – and the order in which reforms are undertaken within sectors – for example, whether in the case of capital account liberalization, foreign direct investment or short-term capital flows should be liberalized first.”

The speed of adjustment, the authors emphasized, will be influenced by the sequencing across and within sectors, and the extent that it needs time.

A large number of economists are not convinced by these arguments, and wonder whether there really is a right sequence.