You are here
The decision in this context should reflect the actual environment in which a company operates. In general, the WACC is estimated using the following equation:. The WACC seems easier to estimate than it really is. Just as two people will rarely interpret a piece of art the same way, neither will two people calculate the same WACC. Even if two people do reach the same WACC, all the other applied judgments and valuation methods are likely to ensure that each has a different opinion regarding the components that comprise the company value.
Therefore, the following sections of this article will discuss the different WACC components in more detail. Errors that are frequently encountered in practice will be highlighted as well as best market practice as a guide for estimating the WACC. The first step in developing an estimate of the WACC is to determine the capital structure for the company or project that is being valued. This provides the market value weights for the WACC formula. Best market practice is to define a target capital structure and this is for several reasons. First, the current capital structure may not reflect the capital structure that is expected to prevail over the life of the business.
The second reason for using a target capital structure is that it solves the potential problem of circularity involved in estimating the WACC, which arises when calculating the WACC for private companies. For instance, we need to know market value weights to determine the WACC but we cannot know the market value weights without knowing what the market value is in the first place. A capital structure can comprise three categories of financing: interest-bearing debt, common equity and hybrid capital.
For equity, market prices are available for public companies, but it is more difficult to identify the market value of equity for private companies, business units and also for illiquid stocks.
The same applies for public debt, such as bonds, where the market value can be identified from available market prices. In the case of private debt, however, such as bank loans and private placements, the current value needs to be calculated. For discussion about the difficulties of calculating the market value of hybrid capital, please refer to the third article in this series on the WACC. The conclusion is that estimating the current capital structure based on market values could be difficult when market prices are not available. The next approach could assist in solving this difficulty, by estimating a target capital structure based on information from comparable companies.
In addition to estimating the market value-based capital structure currently and over time, it is useful to review the capital structures of comparable companies as well.
There are two reasons for this. First, comparing the capital structure of the company with those of similar companies will help to understand if the current estimate of the capital structure is unusual. The second reason is a more practical one because in some cases it is not possible to estimate the current financing mix for the company. For privately held companies, a market-based estimate of the current value of equity is not available. For instance, is the company by philosophy more aggressive or innovative in the use of debt financing?
Or is the current capital structure only a temporary deviation from a more conservative target? Often companies finance acquisitions with debt they plan to amortize rapidly or refinance with equity in the near future. The tax treatment for the different capital components — such as interest-bearing debt, common equity and hybrid capital — is different. The corporate tax rate in the earlier mentioned WACC equation is applicable to debt financing because in most countries interest expense on debt is a tax-deductible expense to a company.
It is appropriate, however, to take into consideration the fact that several countries apply thin capitalization rules that may limit tax deductibility of interest expenses to a maximum leverage. Furthermore, in some countries, expenses on hybrid capital could be tax deductible as well. In that case the corporate tax rate should also be applied to hybrid financing and the WACC equation should be changed accordingly.
For more information on hybrid capital please refer to the third article of this series on the WACC. Finally, corporate tax can also have a positive impact on the cost of equity. An example is Belgium, which recently introduced a system of notional interest deduction, providing a tax deduction for the cost of equity. This system will be further explained in the fifth article of this series, which elaborates on the impact of notional interest deduction on the WACC.
The main conclusion is that the application of the corporate tax rate in the WACC equation will differ per country. As mentioned before, when estimating the WACC for a company, there is a clear trade-off between theoretical purity and actual circumstances faced by the company.
Elsevier - Capital investment financing - a practical_guide_to_financial_evaluation
Best market practice is to reflect the actual environment in which a company operates. Therefore the WACC equation needs to be revised accordingly. The category of interest-bearing debt consists of short-term debt, long-term debt and leases. Many companies have floating-rate debt, as an original issue or artificially created by interest rate derivatives.
If floating-rate debt has no cap or floor, then it is best market practice to use the long-term debt interest rate. This is because the short-term rate will be rolled over and the geometric average of the expected short-term rates is equal to the long-term rate. The cost of debt is calculated using the marginal cost of debt, i. This cost is a combination of the risk-free rate and a debt risk premium. Credit ratings are the primary determinants of the debt risk premium.
More information on the relationship between the WACC, shareholder value and credit ratings can be read in the second article of this series on the WACC. The risk-free rate is the theoretical rate of return attributed to an investment with zero risk. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a specified period of time. In theory, the risk-free rate is the minimum return an investor should expect for any investment. In practice, however, the risk-free rate does not technically exist, since even the safest investments carry a very small amount of risk.
Therefore best market practice for WACC estimations is to use the yield on a year government bond as a proxy for the risk-free rate. Estimating the WACC can be a challenging exercise, however, because a risk-free government bond is not always available in emerging markets.
Corporate finance - Wikipedia
This will be discussed further in article seven of this series. The cost of debt is the yield-to-maturity on publicly traded bonds of the company.
Failing availability of that, the rates of interest charged by banks on recent loans to the company would also serve as a good cost of debt. When using yield-to-maturity to estimate the cost of debt it is important to make a distinction between investment and non-investment grade debt. For investment grade debt, the risk of bankruptcy is relatively low. Therefore, yield-to-maturity is usually a reasonable estimate of the opportunity cost.
The coupon rate, which is the historical cost of debt, is irrelevant for determining the current cost of debt. Best market practice is to use the most current market rate on debt of equivalent risk. A reasonable proxy for the risk of debt is a credit rating. When dealing with debt that is less than investment grade, pay attention to the difference between the expected yield-to-maturity and the promised yield-to-maturity.
The latter assumes that all payments coupon and principal will be made as promised by the issuer. Therefore it is necessary to compute the expected yield-to-maturity, not the quoted, promised yield. This can be done based on the current market price of a low-grade bond and estimates of its expected default rate and value in default. Examples, and Exhibits. Capital Expenditure on Tangible Assets. Acquisitions — an Overview. Corporate Valuation. Acquisition Structuring and Evaluation.
Long Term Capital Management. Short Term Capital Management. Interest Rate Risk. Currency Risk. Appendix A Financial Ratios. Appendix B Pricing Techniques. Appendix C Leasing. Appendix D Examples. Christopher Agar FCA MCT is an independent corporate financial consultant, having previously worked in corporate recovery Price Waterhouse, now part of Pricewaterhouse Coopers and the corporate finance department of an international telecommunications provider.
We are always looking for ways to improve customer experience on Elsevier. We would like to ask you for a moment of your time to fill in a short questionnaire, at the end of your visit. If you decide to participate, a new browser tab will open so you can complete the survey after you have completed your visit to this website. Thanks in advance for your time. Skip to content. About Elsevier.
Search for books, journals or webpages All Pages Books Journals. View on ScienceDirect. Authors: Chris Agar. Hardcover ISBN: Imprint: Butterworth-Heinemann.