Title: Understanding WACC and How Best to Determine What Capital Structure is Optimal for your Business
1Understanding WACC and How Best to Determine What
Capital Structure is Optimal for your Business
- Presented by
- Rod Hewlett
- Executive Vice President and Chief Academic
Officer - Walsh College
2Basic Concepts
- Capital Components funds provided by investors
with an expectation of a financial return on
their investment. - Common Forms of Capital Components
- Common equity
- Preferred equity
- Debt
- The required rate-of-return for each form of
capital component is called its component costs. - The cost of capital associated with capital
budgeting decisions is typically a weighted
average of the various components costs
typically called the weighted average cost of
capital (WACC)
3Basic Concept
4Basic Concepts
- The mix of debt and equity is known as the firms
Capital Structure. - Target Capital Structure is the percentage of the
total capital that firms target to finance the
firm. - An example 20 debt, 10 preferred, 70 common
- Levels of debt and equity change over time
however, most firms attempt to stay close to an
approved target capital structure that is
designed to maximize a firms value.
5Determining Cost of Debt
- Determine rd (cost of debt) the rate of return
debt holders require. - Some companies use fixed, floating, straight and
convertible debt (with and without sinking fund). - Estimate based on long-term debt that will be
used to fund capital projects. (Note short-term
debt is typically not used to fund long term
assets) - After tax rd rd(1-T).
- Determine current yield to maturity (or yield to
call) for outstanding issues. - Adjust for any known credit/risk adjustments
between now and potential project funding.
6Determining Cost of Preferred Stock
- No tax adjustments are required.
- rps Dps / Pn
- Where,
- rps component cost of preferred stock,
- Dps preferred dividend,
- Pn price received by the firm after deducting
flotation costs. - A practical issue arises from the use of a
sinking fund that limits the unlimited life
feature of preferred stock valuation (calculation
used above).
7Determining the Cost of Common Stock
- New issue or retained earnings.
- Few mature firms issue new shares of common stock
according to Brigham and Daves, less than 2
percent of all new corporate funds come from the
external equity market (high flotation costs, new
stock signal, dilution of equity position). - 2 estimation methods CAPM or discounted cash
flow model.
8Capital Asset Pricing Model
- Estimate the risk-free rate (see handout on
CAPM). - Estimate the current expected market risk
premium, RPm. - Estimate the stocks beta coefficient, bi , and
use it as an index of the stocks risk. - Substitute the values in the CAPM equation to
estimate the required rate of return on the stock
in question. - rs rRF (RPm)bi.
9Estimating Parameters of CAPM
- According to Bruner, Eades, Harris, and Higgins
(Best Practices in Estimating the Cost of
Capital Survey and Synthesis, Financial
Practices and Education, Spring/Summer 1998,
13-28), about 2/3 use the rate on long-term
Treasury bonds for the risk free rate of return. - Market Risk Premium
- RPm rm rRF
- Use historical Ibbotson Associate data since
1926 arithmetic average 7, geometric average
5.4 (some use a 3-7 range if using data since
1960 Bruner, et al.). - Use Fama French estimate (The Equity Premium,
JOF, 27(2)) estimated in the 2.55 range. - Use 60 year average of about 5.7 (Bruner, et
al). - 400 basis points on an actualized basis/or
investment bankers estimate. - Beta, regress the companys stock against SP 500
(or other appropriate index) for at least 15
periods and use the slope coefficient (company is
the dependent variable).
10Discounted Cash Flow
- Estimated rs D1 / P0 expected g, where
- D1 dividend one period hence.
- P0 current price of the companys stock.
- g historical income growth rates less
historical retentions for retained earnings (for
constant growth). Alternate use consensus
analysts forecast for growth.
11Weighted Average Cost of Capital (WACC)
- WACC wdrd(1-T) wpsrps wcers.
- w weights of each component based on
- Based on accounting values on the balance sheet
(book values). - Current market values of the capital structure.
- Managements targeted capital structure for the
future. - Firm can control capital structure but cannot
control level of interest rates, market risk
premium, tax rates. - WACC is the marginal dollar of capital (raising
new money).
12Capital Structure Considerations
- The value of a firm is the present value of its
expected future free cash flows, discounted by it
WACC. - Firms can thus change value by
- Affecting free cash flows
- Adjusting the cost of capital
13Capital Structure Considerations
- Sales stability stable cost and revenue may
allow more fixed (debt) charge. - Asset structure firms with assets that can be
bond or mortgage backed tend to use more debt. - Operating leverage firms with less operating
leverage are better able to employ financial
leverage due to less business risk. - Growth rate firms that are mature and fast
growing use more debt, firms that face great
uncertainty typically use more venture or equity
capital. - Profitability firms with high levels of profits
tend to use less debt (Microsoft, Coca-Cola,
Intel). - High tax firms may benefit from the deductibility
of debt.
14Capital Structure Considerations
- Control owners (or owner managers) may desire
debt to preserve control of the firm. - Lender and rating agency attitudes if rating
agency will take adverse action on more debt,
equity may be used. - Market conditions.
- Internal conditions/timing picking the right
time tactically to issue stock based on announced
higher earnings. - Financial flexibility good time (any type) and
in bad times debt due to the secured position.
15Capital Structure Theory
- No agreement on what constitutes the best or
ideal structure. - Tradeoff theory firms seek debt levels that
balance the tax advantages of additional debt
against the cost of possible financial distress
(moderate borrowing by tax-paying firms). - Pecking order theory firms will borrow, rather
than issuing equity, when internal cash flow is
not sufficient to fund capital expenditures. The
amount of debt will reflect the firms cumulative
need for external funds.
16Capital Structure Theory
- Free cash flow theory dangerously high debt
levels will increase value, despite the threat of
financial distress, when a firms operating cash
flow significantly exceeds its profitable
investment opportunities. Designed for mature
firms that are apt to over invest. - MM (1958) in an environment of assumed perfect
and frictionless capital markets, where financial
innovation quickly extinguishes deviations from
predicted equilibrium, the choice between debt
and equity financing has no material effects on
the value of the firm or on the cost of
availability of capital.
17Risk and Timing Issue with Using WACC
- In a 1980 article by James A. Miller and John R.
Ezzell, two key issues are raised - Are the estimated cash flows from the proposed
project, merger, or acquisition at the same risk
level of the firms historical risk level? - Is the use of the WACC as a discount factor
appropriate for uneven finite cash flows? The
authors note that it is generally accepted that
using the WACC as a discount tool for a one-year
project life or level perpetual project cash
flows is appropriate. - The finding of the analysis is that the critical
discount factor relates not to project life but
concerns the financing policy followed by the
firm. - If the amount of leverage differs from target
or the risks associated with cash flows differ
from the initial assumption, then the WACC
discount is not valid for extended life
discounting. Maintain constant leverage ratio by
adjusting outstanding debt or maintaining
constant internal and external risk factors over
an extended period is difficult (or impossible). - The authors suggest using Stewart C. Myers
Adjusted Present Value (APV) from JOF, 29(1),
pp. 1-25 - Miller, J.A. Ezzell, J.R. (1980). The Weighted
Average Cost of Capital, perfect Capital Markets,
and Project Life A Clarification, The Journal of
Financial and Quantitative Analysis, 15(3), pp
719-730.
18Myers Adjusted Present Value (APV)
- The term adjusted present value is used because
in the optimal solution, the projects direct
contribution is adjusted for the projects side
effects on other investment and financing
options. The side effects occur because of the
projects effects on the debt capacity and
sources/uses constraints. - Using a WACC discount methodology using MMs
formula is acceptably accurate if attention is
restricted to projects that do not shift the
firms risk class or target debt ratio. - Steps to using an APV approach
- Determine the NPV formula.
- Estimate the projects contribution to firm debt
capacity. - Determine whether the marginal source of equity
financing is additional retained earnings,
additional stock issue, or a reduction in share
repurchase. - Adjust discount factor for risks identified in
above steps.
19Best Practices in Estimating the Cost of Capital
- From Bruner, R. F., Eades, K.M., Harris, R.S.,
R.C. Higgins, Financial Practice and Education,
Spring/Summer 1998, pp.13 -27. - Survey of 27 highly regarded corporations, ten
leading financial advisers, and seven best
selling textbooks and trade books. - Findings
- Close alignment among all groups on the use of
common theoretical frameworks and on many aspects
of estimation. - Large variation for the joint choices of the
risk-fee rate, beta, and the equity market risk
premium, as well as for the adjustment of capital
costs for specific investment risks.
20Key Best Practices Findings
- Discounted Cash Flow (DCF) is the dominant
investment-evaluation technique. - WACC is the dominant discount rate used in DCF
analyses. - Weights are based on market not book value mixes
of debt and equity. - The after-tax cost of debt is predominantly based
on marginal pretax costs, and marginal or
statutory tax rates. - CAPM is the dominant model for estimating the
cost of equity. Some firms use APT. No firm cited
specific modifications of CAPM to adjust for
empirical shortcomings. - See Best Practices handout for detailed findings.
21Use of EVA
- Net sales operating expenses taxes capital
charges EVA. - Picks up the relationship between knowledge and
value added. - EVA proxy for RO intellectual capital. (Marchant
and Barsky, Invisible but valuable, 1997,
presented paper)
22Balanced Scorecard
- Measuring many variables
- Tool to discern value creation
- Systematic
- Not project related