Understanding WACC and How Best to Determine What Capital Structure is Optimal for your Business

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Understanding 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

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Basic 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)

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Basic Concept

• Balance Sheet

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Basic 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.

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Determining 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.

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Determining 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).

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Determining 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.

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Capital 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.

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Estimating 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).

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Discounted 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.

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Weighted 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).

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Capital 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

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Capital 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.

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Capital 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.

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Capital 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.

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Capital 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.

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Risk 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.

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Myers 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.

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Best 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.

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Key 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.

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Use 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)

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Balanced Scorecard

• Measuring many variables
• Tool to discern value creation
• Systematic
• Not project related