The WACC is calculated on an after-tax basis, since free cash flows represent cash available to all providers of capital (Damodaran, 2002). It is imperative to note that when calculating free cash flows there is a deduction of national tax charge from the Earnings Before Interest and Tax (EBIT) to determine Net Operating Profit After Tax (NOPAT).
The formula for the WACC of a company with two sources of capital is set out below (Rappaport, 1998)
WACC (Kd x (1 t)) x (DT) Ke x (ET)
Where,
Kd Cost of debt
t Tax rate
D Total debt (market value)
E Total equity (market value)
T Debt Equity (market values)
Ke Cost of equity.
Calculation of Weighted Average Cost of Capital (WACC)
However, most finance textbooks present the Weighted Average Cost of Capital WACC calculation as
WACC Kdx x (1 t) x D Ke x E
Where Kd is the cost of debt before taxes, T is the tax rate, D is the percentage of debt on total value, Ke is the cost of equity and E is the percentage of equity on total value. All of them precise (but not with enough emphasis) that the values to calculate D y E are market values. Although they devote special space and thought to calculate Kd and Ke, little effort is made to the correct calculation of market values.
Case Study Vodafone
Generally speaking, calculation of WACC is relatively simple for small organizations (Adler, 1974). However, for a multinational corporation like Vodafone calculating WACC is a tedious job and requires a lot of number crunching. Therefore, some of the small steps in calculating WACC have not been shown in the paper.
The calculation of Vodafones weighted average cost of capital requires 3-step process
Components of Cost of Capital
First, the cost of each kind of capital that the enterprise uses is calculated or inferred, namely debt and equity (Anderson, 2003).
Debt Capital The cost of debt capital is equivalent to actual or imputed interest rate on the companys debt, adjusted for the tax-deductibility of interest expenses. Specifically
The after-tax cost of debt-capital The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in )
Equity Capital Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, the opportunity cost of equity capital is also inferred (Cumming, 2005).
Capital Asset Pricing Model (CAPM) CAPM says that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. This extra risk is often called the equity risk premium, and is equivalent to the risk premium of the market as a whole times a multiplier called beta that measures how risky a specific security is relative to the total market (Emery, Douglas, Finnerty, and Stove, 1998).
Thus, the cost of equity capital Risk-Free Rate (Betatimes Market Risk Premium).
Capital structure
Next, the proportion that debt and equity capital contribute to the entire enterprise is calculated, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return.
Weighting the Components
Finally, the cost of each kind of capital by the proportion that each contributes to the entire capital structure is weighted. This results into Weighted Average Cost of Capital (WACC), the average cost of each employed in the business (Harris and Raviv, 1991).
The following is the summary of WACC calculation for Vodafone
DebtEquityTotalPre-tax cost of debt ()3.8Cost of equity ()8.3After-tax cost of debt ()2.8Market value of debt (, MM)500.0
Market value of equity (, MM)76,272.0Enterprise Value (, MM) 76,772.0Percent of enterprise value ()0.7Percent of enterprise value ()99.3Percent of enterprise value ()100.0Weighted Average Cost of Capital (WACC, )8.3 Data Sources www.vodafone.com
Uses of WACC
Profitability Valuation
Economic indicators emerged with the realisation that profitability per se cannot fully measure value because it does not factor in risks. To measure value, returns must also be compared with the cost of capital employed. Using the cost of financing of a company, WACC, it is possible to assess whether value has been created (i.e., when return on capital employed is higher than the cost of capital employed) or destroyed (i.e., return on capital employed is lower than the cost of capital employed).
Value of Operations
The weighted average cost of capital (WACC) blends the required rates of return for debt (kd) and equity (ke) based on their market-based target values (Harvey, 1991). This is useful because the interest tax shield has been excluded from free cash flow (because interest is tax deductible). Since the interest tax shield has value, it must be incorporated in the valuation. Enterprise DCF values the tax shield by reducing the weighted average cost of capital. By calculating free cash flow as if the company were financed entirely with equity, operating performance across companies and over time without regard to capital structure can be compared. By focusing solely on operations, a cleaner picture of historical performance can be developed, and this leads to better forecasting.
Risk Extraction
A companys WACC already reflects its weighted average risk premium. In theory, the value of the weighted average risk premium could be extracted simply by subtracting the risk-free rate from the WACC. In practice, it is better to follow a slightly different procedure because the company cannot actually borrow at the risk-free rate. Instead of subtracting the risk-free rate, the companys expected after-tax borrowing rate is subtracted (Marino and Matsusaka, 2005)
Weighted Average Risk Premium WACC - Cost of Debt After Tax
For consistency, financial analysts use the same after-tax cost of debt as used in the WACC. This prevents double-counting the companys credit risk premium in the subsequent calculations. The credit risk premium is the additional interest above the risk-free rate that the company must pay to compensate lenders for the possibility that the company might default on its payments to lenders.
Projecting Risk Premium
The risk-adjusted WACC for a project or for its risk class can be obtained simply by adding to the companys expected WACC the difference between the projects risk premium and the companys risk premium
Adjusted WACC WACC (Project Risk Premium - Company Risk Premium)
The resulting risk-adjusted WACC provides discount rates reflecting the differing risks of the companys projects.
Limitations of WACC
Complexity
Although applying the weighted average cost of capital is intuitive and relatively straightforward, it comes with some drawbacks. If one discounts all future cash flows with a constant cost of capital, as most analysts do, one is implicitly assuming the company manages its capital structure to a target rate. For example, if a company plans to increase its debt-to-value ratio, the current cost of capital will understate the expected tax shields. Although the WACC can be adjusted for a changing capital structure, the process is complicated.
Assumptions for Weighting System
Calculation of WACC is based on a critical assumption that the firm will in fact raise capital in the proportions specified. Because the firm raises capital marginally to make marginal investments in projects, analysts need to work with the marginal cost of capital for the firm as a whole. This rate depends on the package of funds employed to finance investment projects. In other words, the concern is with new or incremental capital, not with capital raised in the past. For the WACC to represent a marginal cost, the weights employed must be marginal. That is, weights must correspond to the proportions of financing inputs the firm intends to employ.
Adjusting Flotation Costs
Flotation Costs involved in the sale of debt instruments, preferred stock, or common stock affect the profitability of a forms investments. In many cases, the new issue must be priced below the market price of existing financing. In addition, there are out-of-pocket flotation costs. Owing to flotation costs, the amount of funds the firm receives is less than the price at which the issue is sold. The presence of flotation costs in financing requires that an adjustment be made in the evaluation of investment through WACC.
After-Tax Assumptions
Kdx (1-T), the after tax cost of debt, implies that the tax payments coincides in time with the tax accrual. Some firms could present this payment behaviour, but it is not the rule. Only those that are subject to tax withheld from their customers, pay taxes as soon as they invoice their goods or services. Because of this tax assumption and the existence of changing macroeconomic environment, (say, and inflation rates) WACC changes from period to period.
Use of WACC in International Scenario
WACC versus APV
Given the estimates for cost of equity and after-tax cost of debt, the debt and equity weights need to be derived an estimate of the weighted average cost of capital. In emerging markets, many companies have unusual capital structures compared with their international peers. One reason is, of course, the country risk (Masson, 1990). The possibility of macroeconomic distress makes companies more conservative in setting their leverage. Another reason could be anomalies in the local debt or equity markets. In the long run, when the anomalies are corrected, the companies should expect to converge to a capital structure similar to that of their global competitors. One could forecast explicitly how the company evolves to a capital structure that is more similar to global standards. In that case, using APV approach is a more useful option (Plasschaert, 1985).
Selection of Discount Rate
One question that a company investigating a foreign investment in an emerging market should ask is which hurdle rate should be used There are three different types of discount rates. The first method is to use the corporate WACC. Analysts in favour of using one single corporate WACC argue that a multinational organization can be considered as a portfolio of multiple (global) investments and thus each investment can be treated with the same cost of capital, which reflects the companys total aggregated portfolio risks.
The second method is to consider each investment project as a stand-alone investment and value each of them according to a local WACC that reflects the risks of the local country and project. The third method is a middle-of-the-road approach, which recognizes the need to account for the additional sovereign risk factors in the country of the investment in the WACC. This is achieved by simply adding a sovereign risk premium to the corporate WACC as a mark-up.
International capital structure
The key idea is to seek the lowest WACC in whatever currency it is the least, and then use the conversion rule to measure the WACC in the other currency. It is important to use the interest rate on risk-free T-bills for conversion purposes. That allows the costs of capital to be adjusted for different inflationary expectations, as in the Fisher equation. It is appropriate to consolidate all debt and equity at current exchange rates in order to correctly measure the debt-to-equity ratio for global operations.
Specific Risk Adjustments in the WACC
Calculating the WACC in developed markets can be a complicated exercise, but the calculation in emerging market environments is even more demanding. As well as the different and additional risks mentioned, emerging markets are also less developed, liquid and accordingly less efficient. In other words, reliable information for the determination of the WACC will be harder to obtain.
Cost of equity
The first component of the WACC is the cost of equity. In developed markets the capital asset pricing model (CAPM) is mostly applied to estimate the cost of equity of an investment. But CAPM has one significant underlying theoretical assumption, which is that it assumes that markets are fully integrated and efficient. However, there is proof to conclude that emerging markets are not efficient. For fully segmented emerging markets it can even be argued that CAPM is unsuitable compared to WACC for estimating the cost of equity, as the equity prices are not determined by equilibrium situations due to inefficiencies and poor liquidity.
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