Title: A WACC Sanity Check
1A WACC Sanity Check
- Kevin Davis
- Commonwealth Bank Group Chair of Finance
- Department of Finance
- The University of Melbourne
2Operating 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
3Operating 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)
4Estimating 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?
5Estimating 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
6Approach 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
7Key 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
8Key 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
9Key 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
10Key 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
11Key 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.
12Conclusions
- 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.