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8/12/2019 SSF -Final Main

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This euation is the same as saying!

WACC " (percent of the firm that is euity) times (cost of euity)

plus (percent of the firm that is debt) times (cost of debt)

Uses rATIONALEWACC can be used as a hurdle rateagainst which to assess ROIC(return on

investment capital) performance. It also plays a ey role in economic value

added(!"A) calculations.

Investors use WACC as a tool to decide whether to invest. #he WACC

represents the minimum rate of return at which a company produces value for

its investors. $et%s say a company produces a return of &' and has a WACCof . #hat means that for every dollar the company invests into capital* the

company is creating nine cents of value. +y contrast* if the company%s return

is less than WACC* the company is shedding value* which indicates that

investors should put their money elsewhere.

WACC serves as a useful reality chec for investors. #o be blunt* the average

investor probably wouldn%t go to the trouble of calculating WACC because itis a complicated measure that re,uires much detailed company information.

-onetheless* it helps investors now the meaning of WACC when they see itin broerage analysts% reports.

#he WACC is useful in determining how a company gains its capital. Is it

financing itself through debt or e,uity #he WACC helps answer that

,uestion. Computing WACC offers insight into a company%s ability to maereturns upon its investments and* hence* money for investors. #he WACC is

often used by internal management to steer the company toward beneficial*

moneymaing pro/ects and away from losing ones.

3.2 The gearing ratio
http://www.investopedia.com/terms/h/hurdlerate.asphttp://www.investopedia.com/terms/r/returnoninvestmentcapital.asphttp://www.investopedia.com/terms/e/eva.asphttp://www.investopedia.com/terms/e/eva.asphttp://www.investopedia.com/terms/h/hurdlerate.asphttp://www.investopedia.com/terms/r/returnoninvestmentcapital.asphttp://www.investopedia.com/terms/e/eva.asphttp://www.investopedia.com/terms/e/eva.asp


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The weighting used in the formula is the company's gearing. The gearing is ameasure of the ratio of debt to company value (the latter being equivalent to the sum of debt() and equity (1)) and is defined as*-earing +

D E

D

+

There are a number of ways to determine the gearing level, each with a direct effect on thecost of capital*a) 2ased on boo% values* the gearing is calculated using the accounting value of thecompany's debt and equity. This is a transparent method, easy to chec% and audit. Thedownside with the use of boo% value is that it is not forward/loo%ing and does not reflectthe company's true economic value. 2esides, boo% values are dependent on theoperator's strategic and accounting policy and so they may vary substantially withchanges in the accounting principles, provided general accounting rules are respected3b) 2ased on mar%et values* the gearing can be calculated on the basis of the observedmar%et value of the company's debt and equity, namely its mar%et capitalisation, which in

theory will reflect the true economic value of the company's capital structure. The mar%etvalue of equity can be obtained by multiplying the number of shares with their currentprice. The mar%et value of debt can be difficult to obtain directly since besides bondsfirms generally have other forms of non/traded debt, such as ban% debt. 4owever, boo%values can be converted into mar%et values by treating the entire boo% debt as onecoupon bond.5 This coupon bond would be valued at the current cost of debt for thecompany. 4owever, the problem with the use of mar%et values is that they are dependenton several mar%et factors, namely volatility, investors' expectations and speculation andso they can be sub$ect to serious fluctuations, negatively affecting mar%et stability.

(v)

Determining the Costs of Financing

#n order to determine the WACC, the costs of the individual sources of long term

financing

there are four sources of capital!

$) %ebt

&) 'referred toc

*) Common toc

+) #nternally generated funds (retained earnings)

Debtis money the company borrowsand has to pay intereston, $ust thesame as we might borrow money from the ban%. The company will thenhave to pay interesteach year which will be a set percentage of theamount they have borrowed. They need to ma%e these repayments no


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matter what, whether they ma%e a profit or not. 4owever the amount ofdebt doesn6t increase over time li%e the value of the company does.

3.3 The cost of debtThe cost of debt reflects the cost the company has to sustain in order to get capital tofinance its activity, either from financial institutions or through loans from other companies. #tcorresponds to the weighted average of the costs of the various long/run loans of thecompany and it is strongly correlated to the current interest rate's level, the company'sfinancial capacity and ris% and even to the country's fiscal policy.The cost of debt can be calculated using accounting data or the current loan boo% in orderto derive the interest rate the company registers in its accounting boo%s. This is atransparentmethod, easy to audit, and that considers the costs the company actually paid.

factor to be considered in calculating the cost of debt is to loo% at the firm6s credit ratingsas an indication of borrowing costs.

nother method to ascertain the cost of debt is to calculate an efficient borrowing level. Thiscould be done where firms over borrow or borrow at too high a rate and therefore the levelofdebt and associated interest cost are ad$usted bac% to an efficient level by the regulator sothat the firm is not rewarded for this financial decision.

nother method to estimate the cost of debt is the following*ost of ebt + 7is% &ree 7ate ompany 8pecific ebt 9remiumThe ris% free rate is analysed in more detail in chapter :.; of this document.The company specific debt premium increases with the company's gearing reflecting thecompany's higher financial ris%, considering that more cash flow needs to be generated inorder to meet interest payments. #t can be obtained by observing published credit ratings:that specialist credit rating agencies assign to that company.

lthough it is more complex to calculate, this approach ensures that the cost of debt isforward/loo%ing and, therefore, avoids transitional effects, such as temporary holdings ofdebt

Equity is usually money obtained from selling sharesin the company.ninvestor will give the company money in return for a share of the companyitself. The company is not usually obliged to ma%e any interest paymentson this capital, but most will pay dividends to their shareholders dependingon the profit they have made in a particular period. The shareholder also

benefits from the value of the company (and hence the value of theirshares) increasing over time.

Cost of EquityThe second main component of the formula is the cost of equity. 1conomic theoryhas developed different approaches to calculate the cost of equity, for example the apital


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sset 9ricing


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7equired (or expected) 7eturn + ;A (!5A / ;A)@!.F

7equired (or expected) 7eturn + "#.3$

hat 9< tells us is that Doe's Eyster 2ar has a required rate of return of !G.HA. 8o, if you invest in

DE2, you should be getting at least !G.HA return on your investment. #f you don't thin% that DE2 will

produce those %inds of returns for you, then you should consider investing in a different company.

#t is important to remember that high/beta shares usually give the highest returns. Ever a long period of

time, however, high beta shares are the worst performers during mar%et declines (bear mar%ets). hile

you might receive high returns from high beta shares, there is no guarantee that the 9< return is

reali?ed.

Cost of equity

ost of equity + 7is% free rate of return 9remium expected for ris%

ost of equity + 7is% free rate of return 2eta x (mar%et rate of return/ ris% free rate of

return) here 2eta+ sensitivity to movements in the relevant

mar%et*

here*

Es

The expected return for a security

Rf

The expected ris%/free returnin that mar%et (government bond yield)

s

The sensitivity to mar%et ris%for the security

RM

The historical return of the stoc% mar%et> equity mar%et

(RM-Rf)

The ris% premiumof mar%et assets over ris% free assets.

The ris% free rate is ta%en from the lowest yielding bonds in the particular mar%et, such

as government bonds.

(or required rate of return for investors) can be calculated with the "dividend

capitali?ationmodel", which is
http://www.investopedia.com/terms/b/bear.asphttp://en.wikipedia.org/wiki/Risk-free_returnhttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Equity_markethttp://en.wikipedia.org/wiki/Equity_markethttp://en.wikipedia.org/wiki/Risk_premiumhttp://en.wikipedia.org/wiki/Government_bondshttp://en.wikipedia.org/wiki/Dividend_discount_modelhttp://en.wikipedia.org/wiki/Dividend_discount_modelhttp://www.investopedia.com/terms/b/bear.asphttp://en.wikipedia.org/wiki/Risk-free_returnhttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Equity_markethttp://en.wikipedia.org/wiki/Risk_premiumhttp://en.wikipedia.org/wiki/Government_bondshttp://en.wikipedia.org/wiki/Dividend_discount_modelhttp://en.wikipedia.org/wiki/Dividend_discount_model


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The ris% free rate&rf'

The ris% free rate is the expected return on an asset, which bears in theory no ris% atallI, i.e. whose expected returns are certain. #n practice, it is not possible to find aninvestment that is free of all ris%s. 4owever, freely traded investment/gradegovernment bonds can generally be regarded as having close to ?ero default ris%and ?ero liquidity ris%.

The ris% pre!iu!The mar%et ris% premium represents the additional return over the ris%/free rate thatinvestors require as compensation for the ris% they expose themselves to byinvesting in equity mar%ets. #t is essentially a measure of investors6 appetite for ris%What Does Beta(ean)

measure of the volatility, or systematic ris%, of a security or a portfolio in comparison to the mar%et as a

whole. 2eta is used in the capital asset pricing model (9


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dp" fied annual preferred dividend.

'p"price of preferred

rp"cost of preferred euity

rd

0p

p

p

=

ote that it is actually the netissuing price that should be used in this euation. That is,

the price of the preferred stoc net of any flotation costs that would have to be incurred

in order to issue new shares.

4.Cost of retained earnings!ost of internal e"#it$

Jote that retained earningsare a component of equity, and therefore the cost of retained

earnings (internal equity) is equal to the cost of equity as explained above. ividends

(earnings that are paid to investors and not retained) are a component of the return on

capital to equity holders, and influence the cost of capital through that mechanism.

In order to calculate a weighted average cost of capital there are a few pieces of information that we

need to know:

TheWd= The proportion of the financing taken on by debt (amount of capital taken from loans/initial

investment)

The Wpd! The proportion o the inancing ta"en pro#ided $% preerred stoc" (a&o'nt o

capital ta"en ro& preerred stoc"initial in#est&ent)

TheWe! The proportion o the inancing pro#ided $% e'it% (a&o'nt o capital raised $%ne* e'it%initial in#est&ent)

The ater ta+ ,d! The cost o de$t + ( -. ta+ rate) or the interest rate that the $an" re'ires

The ,pd! di#idendshare price

The ,e! /(r)0 1eta (Mar"et /is" Pre&i'&)
http://en.wikipedia.org/wiki/Retained_earningshttp://en.wikipedia.org/wiki/Retained_earnings


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The initial in#est&ent

The ta+ rate

We are no* a$le to calc'late the WACC *hich !

Wd(Kd)(1-t)+(Wpfd)(Kpfd) +(We)(Ke)

ere is a numerical e!ample:We want to start a company that re"uires an initial investment of

#$%%&%%%' ur company that will manufacutre plastic shower caddies will re"uire use of all

#$%%&%%%' We are able to take out a loan of #*&%%% from a local bank+ #*%&%%% by issuing

common stock to family& friends& and professors+ and #*&%%% of preferred stock to a

generous alumna of ,-' There is an . interest rate on our loan+ and we agreed to pay

our alumna 0 return' We do some research and see that a company who only manufactures

plastic shower caddies has a beta of '.* with no outstanding debt' ur risk free rate is 1'1

and market risk premium is 0'0' The ta! rate is 2%' What is our re"uired return on our

investment that we will use to find a present value of our company& in other words& ourW3--4

2OLUTION3

Wd= *&%%%/$%%&%%% = '*

We! 456555-556555 ! 74

Wpd! 846555-556555 ! 784

,d! 759

,e! 75::0794(75;;) ! 7-5

,pd! 75;

5ow we can substitute into our e"uation:

W3--= ('*)('%.)($6'2)7('*)('$)7('*)('%0)

WACC! 75-:0754075-4

! 75


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When finding a rate of return for an individual pro8ect& we must remember that W3-- is only

appropriate for an individual pro8ect when its risk is e"ual to the risk of the company as a

whole' If there is added or subtracted risk to the firm from the pro8ect& the re"uired return

must be ad8usted'

A ne* 1eta or the pro?ect &'st $e o'nd $% 'sing the @a&ada E'ation3

9eta of assets= 9eta of e"uity/ $7($6t)(;/isk 3d8usted ;iscount >ate= risk free rate7 (beta of assets)(market risk premium)

Other practical proble!s in esti!ating the cost ofcapital*." +ntroductionThere may occur circumstances in which the approaches introduced and explained in theprevious chapters to estimate the cost of capital cannot be used. This may be the casewhenthe cost of capital of a non/listed firm has to be estimated3 in fact, when shares are notlisted,there is no information available to estimate the company's beta. 8imilar types of problemsmay arise when a company has not issued debt securities, when a domestic financial

mar%etis not mature enough to estimate the equity ris% premium reliably, or when the financialmar%et volatility raises concerns over the company specific parameters.This chapter presents some alternative approaches that can be used in the aforementionedcircumstances in order to alleviate the uncertainty of estimation in the absence ofsufficiently reliable information from the financial mar%et. #n all of these cases someadditional measures can be adopted in order to avoid errors in estimation. Eneoptionis to use good comparator companies and another one is to use the high>low/method andsensitivity analysis.a) Comparator companies

#n case some of the parameters of the can not be estimated reliably as a

consequence of data unavailability, a useful approach is to base the estimation of theparameters, or of the itself, using comparator companies, as in the case of divisional calculation. hen selecting companies, which have to serve as a comparison, thefollowing aspects should be considered*

The comparator company, or companies, should be comparable in si?e with the

company being evaluated. The si?e can be measured for example in revenues or intotal mar%et capitali?ation3 the latter is not applicable in case of unlisted firm.

&urther, it is preferable that the comparator companies are selected from countries


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which are similar to the country of the relevant company, for example in terms ofincome per capita, as the ris% of telecom business is li%ely to differ depending on theincome level of the country in which companies operate. #n fact, in countries with ahigher income level, the use of a phone is li%ely to be less sensitive to changes inincome, whereas in lower income countries, telephone services are li%ely to havehigher income elasticity.

The penetration rate could also be a criterion for selecting the most appropriate

comparator companies. &or example, a low penetration rate could be an indicationthat phone services are used predominantly by businesses, since the urbanpopulation is li%ely to be more sensitive to the economy.

b) High/low scenario approach and sensitivity analysisThe high>low scenario approach is useful when it is possible to produce various estimates,using different methods, but none of these estimates is clearly more reliable than the others.This is done in practice by identifying the highest and lowest level for each of the envisagedparameters and calculate a range of cost of capital outcomes. The main purpose of the

high>low scenario approach is to average out errors made in individual parameterestimation.#n addition to the high>low scenario approach, sensitivity analysis could be used. Thismeansthat after ma%ing the best estimate of a parameter, one calculates the using thisbestestimate. #n order to determine whether the is vulnerable to errors in the estimationofthis parameter, one can also use the highest and the lowest values of this parameter,produced in the analysis, and incorporate them in the calculation as well anddetermine the effect on the . #f the effect is large, one should consider spending moretime and effort to increase the reliability of the estimation of this one parameter.

.Therefore ta%ing only a recent period ris%s missing information and biasing the results,suggesting that betas should be calculated over as long a period as possible. There istherefore a trade/off between the relevance of the estimation period and the need for asufficiently long time period to ensure the regression results are robust.


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