WACC: Beyond the Basics

Banikanta Mishra
XIM-Bhubaneswar
CID: 2010

WACC from a Portfolio Perspective
If we think of the firm as a portfolio of debt and equity,






But, from the CAPM perspective,
if |
A
is the |eta of the companys Assets,


WACC = R
f
+ |
A
(R
m
R
f
)

So, WACC can be thought of as the R
A
.
E E D D
R W R W WACC then + =
E D
R
V
E
R
V
D
WACC OR + =
4/20/2014 2 Professor Banikanta Mishra
|
A
as a Portfolio |eta
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We know from CAPM analysis that
portfolio-beta is a weighted-average of
|etas of assets in the portfolio



So, taking Company as a portfolio of Debt and Equity,
we can write Companys beta, |
A
, as follows



So, if a companys
|
D
is 0.25 and |
E
is 1.50 while w
D
= 0.20 and w
E
= 0.80,

i i
n
1 i
p
w |

= |
=
E E D D A
w w | + | = |
25 . 1 ) 50 . 1 x 80 . 0 ( ) 25 . 0 x 20 . 0 (
A
= + = |
Tax-Adjusted WACC

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When interest-payments are tax-deductible,
the effective value of Debt is lower;
therefore, the tax-adjusted WACC is lower


This rate is used to discount
UNLEVERED cash flow.

This is the default WACC.
E E c D D
R W ) t 1 ( R W WACC + =
Computing Operating Cash-flow
Net Sales 1,509
- COGS 750
- Non-cash Charges (Depreciation etc.) 65
= EBIT = 694
- Interest 70
= EBT or Taxable Income = 624
- Taxes @34% 212
= EAT or Net Income = 412
+ Non-Cash Charges 65
+ Interest 70
= Cash flow (Actual or Levered) = 547
Professor Banikanta MISHRA 5
Computing Unlevered (Operating) CF
Net Sales 1,509
- COGS 750
- Non-cash Charges (Depreciation etc.) 65
= EBIT = 694
- Interest 0
= EBT or Taxable Income = 694
- Taxes @34% 236
= EAT or Net Income = 458
+ Non-Cash Charges 65
+ Interest 0
= Cash flow (Actual or Levered) = 523
Professor Banikanta MISHRA 6
Actual and Unlevered Operating CF
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What is the relationship between
Actual Operating CF of $547
and UNLEVERED (Operating) CF of $523?

Unlevered CF
= Operating CF (Interest Tax Shield)

= Operating CF (Interest x Tax-Rate)

= $547 ($70 x 34%) = $547 - $24 = $523

So, if we know the Actual Operating CF,
we can derive the Unlevered CF from it,
merely by subtracting ITS (Interest Tax Shield)
Unlevered and Levered |
4/20/2014 Professor Banikanta Mishra 8
How does existence of interest-payments affect |
E
?

To address this, let us first talk about |
E

when there are no interest-payments

This is called the UNLEVERED |eta or |
U
which reflects the riskiness of the business

When we bring in debt-financing |
E
goes up as follows,
as debt-financing adds to risk of equity-holders,
since debt-holders have first right on cash flows




The corresponding RRR is as follows

( )
D U c U E
) t 1 (
E
D
| | + | = |
( )
D U c U E
R R ) t 1 (
E
D
R R + =
Debt-Equity Ratio (DER) and R
E

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We see that R
E
depends on , the Debt-Equity Ratio

So, when Debt-Equity Ratio (DER) changes, so does R
E


Suppose a firms current (target) D/E is 1/3,
while its R
D
is 10% and R
E
is 16.10%


What would happen to R
E
if the firm decides
to change its target DER to 0.40,
If its R
D
is unaffected by the change in DER?
E
D
How R
E
Changes with D/E Ratio
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Assuming its corporate tax-rate t
c
to be standard 34%,
we can obtain, as follows, that its R
U
= 15%








As we know,



So, our new R
E
would be
18 . 0
%) 34 1 (
3
1
1
%) 34 1 (
3
1
) t 1 (
E
D
1
) t 1 (
E
D
V
' D
that noting
,
V
E
R
V
' D
R R
c
c
E D U
=
+

=
+

=
+ = = + = E D' V and ) t (1 D D' where
c
( )
D U c U E
R R ) t 1 (
E
D
R R + =
( ) % 32 . 16 % 10 % 15 %) 34 1 ( 40 . 0 % 15 R
E
= + =
Firm as a Portfolio of Two Divisions
For a firm with two divisions: X and Y,



where a divisions weight represents
the fraction of firm-value accounted for by the division,

But, getting a divisions value is difficult,
and, therefore, so is its weight

Weight should be based on a stock concept (like NFA),
and NOT on a flow concept (like revenue or expense)

Correspondingly, the WACC of the company is

where R
X
is the RRR for Division-X and R
Y
for Division-Y
Y Y X X
R W R W WACC + =
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Y Y X X A
w w | + | = |
Divisional Cost-of-Capital
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WACC is the appropriate discount-rate to value
a project as risky as the overall firm

BUT, when valuing a project for Division-X,
we should use R
X
as the discount-rate,
and similarly R
Y
for Division-Y projects,

assuming that a project for a division
is as risky as the division itself
(that is, the typical project in the division)

But, how do we find out R
X
and R
Y
?
Pure Play Approach: Look at similar firms
Subjective Approach: Fudge factor?

Similar means same business, same leverage (?)
Computing a Firms WACC: Practice
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Required Data (Notice Overlaps):

Growth-Rate in Dividends, Earnings, Prices
Most Recent Dividend and Share Price

Historical Return on firms Stock and Market Index
(or |eta of Firms Stock)

Current Rate on Treasury (90-day / 1-year / )
Historical Index-Treasury Spread
(that is. R
m
R
f
for chosen Index and Treasury)

Coupon-Rate, Amount, Current Price of each Bond issue

Target Debt-Equity Ratio: Market-Value-based
(or Number of Shares Outstanding and Share Price,
Amount or Face Value of Debt for each past issue,
and current Bond Market-Price Quote for each issue)
DDM
CAPM
COD
WEIGHTS
COE
Computing Weighted COD
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Though most firms typically have
one class of common shares,


They would have several issues of debt,
issued at different points of time in past,
with different times-to-maturity, coupon-rates


In such cases, we should compute
average Effective Yield (or YTM)

Market-Value and Cost of Debt
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DERIVED BY US
Coupon Market-Value* % of Total YTM
weight

9.00% $25.32 mil 27.40 8.50%
7.00% $67.08 mil 72.60 8.90%

Total $92.40 mill Weighted Average 8.79%

* Multiplying Amount (or Total Face Value) by Price gives the Market-Value
GIVEN DATA
Coupon Maturity Amount* Current-Price

9.00% 2010 $25 mil 101.28% (of par)
7.00% 2015 $75 mil 89.45%
Market-Value of Equity and Weights
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Suppose the same Company has
one million shares outstanding,
each with a current price of $200

Then its Market Value of Equity =
$200 million

So, the Market-Value Debt-Equity-Ratio
= 92.40 / 200.00 = 46.20%

Moreover,
% 40 . 68 % 60 . 31 % 100
V
E
% 60 . 31
00 . 200 40 . 92
40 . 92
V
D
= = =>
=
+
=
Finding Cost of Equity
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1. DGM (Dividend Growth Model)
Easy to understand and use

BUT,

Does not explicitly take risk into account
AND
Quite sensitive to estimate of g, dividend-growth-rate,
which is all the more difficult to estimate if
Company is not paying dividends
Dividends are not growing at a steady rate

2. CAPM (or SML)
It takes risk explicitly into account
and does not have the problems of DGM

BUT,

Measure of risk (Beta) varies over time
Computing COE
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Suppose we find that this companys
dividend has been growing at a rate of 5%,
and the most recent dividend was $20

So, its DGM COE =



We also find that its | is 0.95,
current 90-day Treasury-Bill yield is 3.45%, and
historical market-treasury spread has been 8.50%,
its CAPM COE is

3.45% + (0.95 x 8.50%) 11.50%

We use average of DGM and CAPM COE = 13.50%
% 50 . 15 % 5
200 $
%) 5 1 ( 20 $
= +
+
~
The Final Act
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| | ( ) | | % 07 . 11 % 50 . 13 x % 40 . 68 %) 34 1 ( x % 79 . 8 x % 60 . 31 WACC = + =
E E C D D
R W ) t 1 ( R W WACC ) Adjusted Tax ( + =
Suppose this company is evaluating a project
that requires $40.00 million in investment,
generates annual EBITs of $5.50 million
over its 10-year life,
and companys tax-rate = 34%.

Ignoring interest, EBT = EBIT = $5.50 million
Net Income = $5.50 million (1 - 34%) = $3.63 million
Unlevered CF = NI + Non-Cash Charge = $3.63 + $4.00 = $7.63
(assuming that $40 million is depreciated straight-line over 10 years)
PV = 7.63 x PVIFA
11.07%,10
= $44.80

So, accept the project as PV > I.