Modelling Innovation CHAPTER 4

Chapter 4

The weighted average cost of capital1

4.1

What is the WACC?

The WACC is the appropriate discount rate of a companys cash flows given its capital structure. The capital structure of a company includes Equity, Debt, as well as other forms of financing (including hybrid securities). The WACC is the average cost of these types of capital, according to the proportion that each represents in the companys capital structure. The WACC takes into account the return for equity and debt holders and is the right discount rate to calculate the Enterprise Value and, based on that figure, the companys Equity Value (and as a result, other measures including share price estimates). The shareholders return on their shares (the return on equity) represents a financial cost to the company and is usually higher than the return demanded by banks and investors in order to extend finance to the company in the form of loans, bonds or other fixed income securities. Equity holders will only obtain returns on their investment after paying off other security holders, due to the nature of the equity contract. Accordingly, equity investors demand a higher return than debt holders or bondholders. The DCF method takes this into account in the WACC, which is a blended cost of capital.

4.2

The WACC equation

The DCF methodology is extremely sensitive to the discount rate and therefore the WACC should be calculated in detail. An interpretation and comparison to reality should be made before using the WACC in the DCF model. The following formula uses the case of a company financed by Equity, Debt
1

2012, Hugo Mendes Domingos and Eduardo Vera-Cruz Pinto

and Preferred Shares. A variation of the same formula would be used if the analysed company used other forms of capital, such as convertibles or other hybrid securities.

Equation 1.

Weighted Average Cost of Capital Formula

In this formula, the WACC is calculated after tax in the sense that the cost of debt taken into account allows for the tax shield impact of debt financing. Interest is usually tax deductible, and as a result, a companys cost of debt should be considered net of the tax savings generated by the fact that the company will reduce its tax payments to the extent that it uses debt as a form of financing. Preferred Shares are presented in the calculation of the WACC without taxation as it is a hybrid form of finance (with both debt and equity characteristics) and its coupon may be classified as a dividend and is usually not tax deductible (except in some countries). For the sake of simplicity, we assume that the interest paid on preferred shares is non tax-deductible.

4.3

What is the Cost of Debt?

The cost of debt in valuation models is the annual cost that the company incurs for being financed by debt (assuming that the model itself is annual). This cost is normally mistaken for the interest rate on bank loans; however there are other debt instruments that dismiss this simplistic view, including bonds,

Modelling Innovation CHAPTER 4 bank loans and other forms of fixed income financing. What is needed is a general formula that takes into account the fact that the same company could be financed using various forms of debt or via the fixed income capital markets. The formula for determining the cost of debt is as follows:

Equation 2.

Cost of Debt = + +

The Risk Free Rate for the Cost of Debt and the Country Risk Premium
This parameter is the minimum cost of debt (if the spread is zero) and is theoretically a zero-coupon bond. Since zero-coupon bonds are not immediately

available at all maturities, an acceptable estimation is to use the yield on a Government bond. At first, the analyst might have the tendency to bonds of the country where the company is headquartered. In practice, this is not the best approach. For European countries, we recommend the use of a German bund, especially if the company consolidates in euros. The specific risk associated with the country is captured by the country risk premium (CRP), which is described later on. In the case of a UK company reporting in Pounds Sterling, the UK Government bond yield should be used. In that case, there is no need to use the CRP since the Government bond used as a proxy for the Risk Free Rate captures the countrys risk. The same principle would apply to a German company. For companies that operate in various countries, a separate analysis should be conducted for every country that is a material contributor to the revenues. In those cases, a specific WACC (and a specific cost of debt) should be calculated for each country. The analyst should use bonds with maturity equal to the projection period of valuation. When in doubt, the standard favoured by practitioners is the 10-year bond.

The Spread
This spread is the additional return from the risk-free rate, demanded by banks, creditors or fixed income investors, when extending finance to a

particular company. If the company has issued bonds listed on an exchange, the spread will be calculated based on the yield to maturity of those bonds. If the company has obtained a credit rating, its spread is usually public information or can be obtained from the agency that issued the rating.

For private companies without credit rating and that do not disclose their spread (as is usually the case), there are two options. If the analyst has access to the companys confidential information, the average spread should be calculated as the weighted average of the spreads corresponding to the companys actual debt, with the weight corresponding to the outstanding amount for each loan or security. Note that we do not recommend the use of the spread at which the company can raise finance in the market at the date of valuation since this might be an unusually low or unusually high number. In our view, using the average is a better way to capture the companys average cost of debt across the business cycle. If the analysis has to be performed without having access to confidential information, the best option is often to perform a comparable companies analysis, using quoted comparable companies that disclose their own spreads, or through market consultation.

The Country Risk Premium

This assumption corresponds to the additional premium, which would be demanded by investors in order to invest in a particular country. There are a

number of sources for the CRP. The website of Aswath Damodaran at New York University is often used as it tracks the premiums for a number of countries in a reliable way and is updated regularly. Damodaran calculates the country risk premium for us his website is public therefore in our view there is no need to perform the calculation.

The Inflation Delta

This assumption is useful, for instance, for Eurozone companies that report in euro and have operations in countries outside the Eurozone. In that case, each countrys cash flows should (at least theoretically) be valued separately in local currency. Accordingly, the WACC should vary for each of those countries. The inflation delta captures the difference in the medium to long-run inflation in that particular country. It can be calculated by deducting the non-Eurozone countrys expected inflation projections from the projected euro inflation.

4.4

What is the Cost of Equity?

The cost of equity is the annual cost the company incurs for having issued shares (again, assuming that we are dealing with annual cash flow projections). This cost is normally higher than the cost of debt, as was described earlier, and given the nature of equity, it is not tax deductible. Cost of equity is determined by the following equation:

Equation 3.

Cost of Equity = + ( )

Modelling Innovation CHAPTER 4

What is the companys Beta?

A companys beta represents the sensitivity of a share to market movements, ceteris paribus, when it is analysed individually. A Beta is an empirical

indication of the relation between the return of a shares price and the return of the Market. The beta should be adjusted to take into account the companys capital structure and debt.

Table 1- Beta Value Descriptions

Calculating the Beta

For most quoted companies, market data providers disclose their own calculation of the companys Beta. If the company is not listed, the Beta should be calculated based on a comparable companies analysis. Even for quoted companies, certain adjustments can be made to the companys Beta which improves the DCFs accuracy. In the case of a quoted company, the Beta disclosed by market data providers is often called the Levered Beta, as it reflects the companys capital structure. This structure may be inadequate, influenced by the economic cycle or different from the companys target. The adjustment to be made for valuation purposes is called de-leveraging this Beta and then re-leveraging it. The first step results in an Unlevered Beta, which is a measure of risk for the companys assets, debt-free. It is a pure measure of business risk or sector risk. This is why usually companies that exhibit high business risk have low levels of debt and companies with relative stable business risk have more debt (e.g. utilities). In the second step, the analyst can include an adequate level of debt and re-leverage the Unlevered Beta, producing a Levered Beta that can be used in determining the WACC.

Example Astrazenecas Beta

AstraZeneca is a pharmaceutical company based in the UK with a primary listing on the London Stock Exchange. To calculate its Beta, a database of prices from AstraZenecas share (AZN.L) was composed with a horizon of 12 years. Another list of the prices of the FTSE100 (^FTSE) was also recovered from http://finance.yahoo.com with the same horizon. With the two lists of prices, a cloud of points can be drawn in which both the share and market returns can be measured and compared, these returns include any dividend payments made by either the components of the FTSE100 and Astrazeneca in the horizon chosen. The risk free rate for UK Government Bonds is subtracted to each AstraZeneca and FTSE 100 returns. The result is presented in the chart below, the trend line represents the correlation between the market return and the share return and the equation is the result of the regression. The resulting equation is of the type: ( ) = ( ) +

The expected weekly return of AZNs share is equal to alpha, which is a measure of return of the share without risk (Beta or Market Return equal to zero), and it is the return of the stock if the market return is equal to zero (which renders its value meaningless for this analysis), plus AZNs Beta, which measures the shares response to the market, multiplied by the return of the market portfolio, which is the return of all the shares quoted in the ^FTSE. AZNs Beta is equal to 0,7036.

Modelling Innovation CHAPTER 4

Chart 1 - AZN's Beta 20% 15% 10% 5% 0% -30% -20% -10% -5% 0% 10% 20% AZN.L Linear (AZN.L) y = 0.7036x + 0.0005

-10%
-15% -20% -25%

Unleveringand Re-levering the Beta.

Equation 4.

Unlevering the Beta

(1+( ) (1)+( ))

Equation 5.

Re-levering the Beta = (1 + ( ) (1 ) + ( ))

( ) ( ) ( ) ( ) ( )

What is the Market Risk Premium?

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