A WACC Sanity Check

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A WACC Sanity Check

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Title: A WACC Sanity Check


1
A WACC Sanity Check
  • Kevin Davis
  • Commonwealth Bank Group Chair of Finance
  • Department of Finance
  • The University of Melbourne

2
Operating and Financial Risk
  • Financial arrangements can change value of a
    business activity
  • Tax shields, agency issues, signalling
  • Equivalently
  • Financial arrangements can change required rate
    of return for the cash flows of the business
    activity measured ignoring financing cash flow
    effects
  • Reduce traditional WACC relative to all-equity
    financing
  • Used to value cash flows calculated as if company
    unlevered

3
Operating and Financial Risk
  • Equivalently
  • Cash flows of business inclusive of financing
    arrangement effects such as interest tax shield
    can be modeled
  • Vanilla WACC is appropriate discount rate
  • Equal to cost of capital for all equity financing
    (unless some tax or other effects omitted in cash
    flow modeling)
  • May be some adjustment required if leverage not
    constant (systematic risk of tax shields then
    differs to that of assets)

4
Estimating Vanilla WACC (approach a)
  • Step 1 what is the cost of capital for the
    business activity on all-equity finance basis?
  • CAPM requires asset beta, risk free rate, and
    market risk premium
  • Step 2 are there any other effects of financing
    arrangements not already captured in cash flows?
  • Are all tax effects captured in cash flows?
  • Does debt policy mean some adjustment is
    required?
  • What other costs/ benefits might be considered?

5
Estimating Vanilla WACC (approach b)
  • Given financing arrangements
  • Estimate required rate of return for each type of
    finance (equity, debt) and aggregate
  • Cost of equity - CAPM requires equity beta, risk
    free rate, and market risk premium
  • Cost of debt CAPM or debt margin approach

6
Approach a or b?
  • Both are equivalent, if full information is
    available.
  • In practice, where relevant parameters must be
    estimated using imperfect information
  • approach b appears to give more scope for
    cherry picking

7
Key Issue 1
  • Does the longevity of regulated assets imply use
    of a long term risk free rate of interest in
    calculating WACC? No!
  • No evidence that asset beta is linked to project
    life
  • Individual suppliers of capital (eg shareholders)
    can exit project at any time by trading listed
    equity
  • Regulatory approach means cash flows adjust over
    time to changes in market conditions (real
    financial)
  • Benefits from financing arrangements may depend
    on project life
  • Can be captured in cash flow modeling

8
Key Issue 2
  • Does consistency with estimation of MRP require
    use of long term (10 year) risk free rate? No!
  • MRP is a forward looking guesstimate
  • Historical estimates relevant, but
  • Many good arguments about impact of fundamental
    changes in financial and real markets and tax on
    MRP
  • 10 year bond characteristics and bond markets
    have changed markedly over time

9
Key Issue 3
  • Should Cost of Debt be benchmarked off long term
    bond rate. No!
  • Calculation of cost of debt unnecessary if
    Vanilla WACC calculated using asset beta
  • Asset life and debt characteristics
  • May aim to match interest rate risk of debt with
    that of operating cash flows
  • Maturity and interest rate risk can be easily
    decoupled
  • Credit spread of longer term debt may be
    appropriate
  • But overstates required rate of return spread for
    discounting expected cash flows

10
Key Issue 4
  • Does the debt beta matter? Not much!
  • For a given asset beta
  • Higher debt beta offset by lower equity beta
  • Vanilla WACC calculation should be largely
    invariant to debt beta

11
Key Issue 5
  • Does the Levering - Delevering formula matter?
    Not Much
  • Not needed if asset beta known and vanilla WACC
    calculated directly from that
  • Using Monkhouse formula to estimate equity beta
    involves a non-material difference.

12
Conclusions
  • My preference use cost of capital based on
    asset beta for vanilla WACC
  • But how to determine asset beta?
  • Case for using long term (10 year) risk free
    interest rate is weak.
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