Weighted Average Cost of Capital

Article Summary of 100 words Compared to all other methods, the DCF method is the most commonly and often applied method amongst the valuation practitioners across the globe. It provides a scientific highly approach to valuation, with WACC being its most important component. Per DCF, valuation of any business is obtained by discounting the projected FCFFs at the WACC. WACC is the weighted average cost of capital of all the providers of finance to the firm. Its the opportunity cost of capital to the various financiers of equity and debt to the firm. Its calculated by assigning weights of the various forms of capital (debt, equity) to their respective costs.

Background

The knowledge of valuation and skills in using valuation as a guide to business decisions are prerequisites for success in todays business world. Explicitly or otherwise, all financial management decisions are based on some valuation models, which endeavour to identify the true or fair value of the underlying asset.

Few of the several methods of valuations are listed as under: 1. Net Asset Value (NAV), 2. Profit Earnings Capacity Value (PECV), 3. Discounted Cash Flow (DCF), 4. Market Comparables (aka Multiples), etc.

Although fairly easy to use, the NAV method has lost its significance, albeit not relevance, in todays world. This is because today the value-creating assets enjoyed by the organization may not necessarily reflect in its financial statements, which are not only based on historical cost concept, but are also slave to other accounting conventions. Similarly, the PECV method is not

very highly recommended as it lays high emphasis on past earnings, and not necessarily on future earnings. Further, while the market comparables method is reasonably simple and easy to use, it is akin to the concept of one key for all locks. Hence, if used in isolation, the Multiples method may not be the best, or even relevant at times, solution. Compared to all the other methods, the DCF method requires lot more resources in terms of time and information. Yet, the DCF method, which is based on sound and scientific principles of corporate finance, is most commonly and often applied method amongst the valuation practitioners across the globe.

The focus of this article, however, is not on the suitability/ superiority or otherwise of a particular valuation method, but on the nuances of calculations required for ascertaining the weighted average cost of capital (WACC) as per the requirements of the DCF methodology.

Per DCF methodology, the valuation of any business is obtained by discounting the forecasted free cash flows to the firm (FCFFs) at the WACC. FCFFs mean the residual cash flows; after meeting all operating expenses, taxes, capital expenditure and after changes in working capital but prior to any payments made to any financing stakeholders. Accordingly, interest payment is not considered as an expense while computing free cash flows to the firm. The underlying

assumption is that the value of a business can be measured by the present worth of the net cash benefit (being cash inflows less cash outflows) to be received by it over an explicitly forecasted period and beyond.

WACC is the weighted average cost of capital of all the providers of finance to the firm. It can also be termed as the opportunity cost of capital to the various financiers of equity and debt to the firm. The same can be schematically represented as under:

Please note that for the sake of simplicity and ease of understanding, preference shareholders have been kept out of the scope of this article.

A. Cost of Debt

It is relatively simple to calculate the cost of debt. As the free cash flows are computed net of taxes, cost of debt is also considered on a post-tax basis. Put simplistically, the cost of debt is calculated as under: Kd = Rd (1 t) where: Kd = post-tax cost of debt Rd = coupon rate of interest t = marginal rate of income-tax paid by firm

Of course, the above is a plain vanilla formula. It is always a challenge when the market value of the debt is different from the book values. This happens when the general interest rates in the economy, or, more specifically, the interest rates at which the underlying project can raise funds, are different from the coupon interest rate on the debt securities. This is fairly common in a constantly changing interest rate scenario as has been seen in India in the recent years. The above formula will also be seemingly invalid when the explicit coupon rate is 0%, as in the case of deep discount bonds. Or

amount of principal repayment is different from what is collected at the inception, i.e., when the debt is to be redeemed at a pre-determined premium or, though rare, discount.

Such issues are taken care of by taking the market value of the debt in consideration, while calculating the cost of debt. This is done because the cost of debt needs to reflect the expected rate of return by the investors of debt. The effective cost of debt can be calculated as the rate at which the present value of all future cash flows (net of tax benefits on interest payments) related to that debt financing equals the current market price.

Thus, the cost of debt should be based on the rate of interest at which the business can generate additional debt at the point in time, not on the rate at which it has historically raised debt.

Thus, the various factors that go into the calculation of the cost of debt can be schematically represented as under:

B. Cost of Equity

The cost of equity (Ke) is the minimum rate of expected future return on investment that is expected by the company's shareholders. It can also be termed as the minimum rate of return a firm must offer its equity stakeholders to compensate for their investment, and for bearing some risk. Without doubt, it is the most expensive form of capital for a firm.

While it seems simple in its explanation, due to the intricacies and the numerous variables involved in its calculations, it is amongst the most difficult, nay debatable, aspects of a valuation exercise per DCF methodology.

Some of the methods used for calculation of the cost of equity are: Security Market Line (aka CAPM see below) Bond Yield plus Risk Premium Dividend Capitalisation Model Arbitrage Pricing Model

In spite of being more difficult to compute as compared to the other methods, Capital Asset Pricing Model (CAPM) is the most robust in terms of its fundamentals. Hence, it is the most commonly used and widely accepted methodology of calculation of cost of equity.

B.1. Capital Asset Pricing Model (CAPM)

As per CAPM, Ke is the sum total of the risk-free rate of return plus the firms systematic risk (beta) multiplied by the expected premium on the market index. Simplistically, using the CAPM, Ke is calculated as under: Ke = Rf + (Rm Rf) where: Ke = cost of equity Rf = risk-free rate of return = risk factor of the cash-flows Rm = expected rate on a return on a well-diversified investment portfolio Rm Rf = market risk premium, over and above the risk free rate of return, on a well diversified portfolio

B.1.1. Risk free rate of return (Rf)

Hypothetically, the risk-free rate of return is the return on a security that has no default risk. Generally, a long-term sovereign bond rate is taken as the benchmark for risk-free return. Again, since the WACC is used to discount the FCFFs which are expected to accrue to the firm in perpetuity, the Rf to be considered is the longest term duration that is available in the economy. In India, it is generally the 20-year Treasury Bonds.

B.1.2. Beta

Beta, in normal parlance, measures the volatility of a stock price of a firm relative to that of a given market index. Thus, beta is a symbolic representation of the risks of investment in a particular stock, vis--vis in a well diversified portfolio. This of course is the statistical

interpretation of the beta. The relevance of beta is that is a good indicator of the underlying riskiness of the cash flows which are being evaluated.

Though the beta values for listed securities are readily available, one needs to be careful while using them, as a small change in the beta value can have a significant impact on the valuation. The beta value calculated based on historical data will be fairly sensitive to the underlying variables used for calculation. It will be highly dependant, inter-alia, upon the following: a. Choice of time period covered by the underlying observational data points (one year,. two years, three years, five years, etc.) b. Choice of return interval (daily, weekly, monthly, bi-monthly, quarterly, semi-annually, annually, etc.)

Just to give a sense, the table below sets out the beta values for a few listed companies listed on the National Stock Exchange (with the NIFTY as the representative for the well-diversified portfolio for calculation of Rm) and how they differ due to the change in underlying variables. The table covers the data gathered for the period ended 30 Sept 2008:

Beta as calculated on NIFTY 1 year 2 years 3 years 4 years 5 years

Values Range Min Max

Daily ACC Weekly Monthly Balrampur Chinni Daily Weekly Monthly Daily Bhel Weekly Monthly Daily Grasim Weekly Monthly Daily Maruti Weekly Monthly Daily WIPRO Weekly Monthly

0.68 0.73 0.49 1.31 1.05 1.19 1.12 1.18 1.27 0.71 0.69 0.57 0.68 0.78 0.38 0.78 0.63 0.79

0.77 0.89 0.75 1.16 1.20 1.13 1.09 1.12 1.11 0.74 0.68 0.89 0.76 0.72 0.51 0.85 0.71 0.67

0.84 0.89 1.00 1.12 1.00 1.24 1.09 1.19 1.19 0.87 0.89 1.19 0.90 0.90 0.77 0.93 0.78 0.78

0.81 0.85 0.97 1.17 1.15 1.38 1.06 1.24 1.16 0.86 0.96 1.12 0.92 1.01 0.81 0.98 0.94 0.77

0.85 0.88 0.89 1.14 1.17 1.38 1.12 1.16 1.15 0.87 0.86 1.02 1.00 0.90 0.86 1.02 0.87 0.72

0.68 0.73 0.49 1.12 1.00 1.13 1.06 1.12 1.11 0.71 0.68 0.57 0.68 0.72 0.38 0.78 0.63 0.67

0.85 0.89 1.00 1.31 1.20 1.38 1.12 1.24 1.27 0.87 0.96 1.19 1.00 1.01 0.86 1.02 0.94 0.79

Please further note that the beta values change not just due to the two factors as noted and proved above. Even the choice of the market index, which is the representative of the welldiversified portfolio of investments, can have an impact on the beta values. The table below highlights how the beta value (calculated on monthly observations in the table below) may fluctuate for a company, when the underlying representative of a well-diversified portfolio is changed: 3 years ending 30Sept08 Company ACC Balrampur Chinni Bhel Grasim Maruti Wipro Nifty 1.00 1.24 1.19 1.19 0.77 0.78 Sensex 1.03 1.21 1.19 1.23 0.82 0.78 S&P CNX 500 0.94 1.28 1.05 1.09 0.68 0.69 5 years ending 30Sept08 Nifty 0.89 1.38 1.15 1.02 0.86 0.72 Sensex 0.93 1.36 1.16 1.07 0.92 0.75 S&P CNX 500 0.88 1.44 1.03 0.95 0.73 0.64

Furthermore, the following adjustments have also to be undertaken to avoid any mis-calculations: 1. Beta is a measure of the diversifiable risk (commonly also referred to as unique risk or systematic risk) of the levered equity. Hence, apart from other risks associated with the firm, the risk related with using a particular financing mix or current debt equity ratio (D:E) is also mirrored in the calculated beta of the firm. However, as the DCF methodology is based on the future FCFFs, it is most likely that the D:E of the firm will change over the forecasted period, which in turn will change the risk or the beta of the firm. Hence, while computing Ke, one should use the long-term, target, and sustainable D:E of the firm instead of the current D:E. 2. If a beta can be adjusted with firm specific financial risk, it is advisable to use the beta or the risk of the industry in which the firm is operating instead of the existing beta of the firm. This is based on the theory that all the firms operating in that industry will face the same risk over a period of time, if the financial risk is neutral. However, as different firms have different D:E, using these values will not give a correct picture. To solve this problem, the respective betas of the comparable firms are first un-levered and the average un-levered beta of the industry is computed. The un-levered beta measures the business risk of a company after negating the effect of financial leverage. Then the re-levered beta is

computed by using the target D:E of the target firm. While there are various formulae proposed by various valuation experts for re-levering the beta of a firm, the chief amongst them is the one proposed by Aswath Damodaran, which is as under: L = u + u D (1 t) / E where: L = re-levered beta u = un-levered beta D = weightage of debt in D:E t = marginal tax rate considered for calculation of cost of debt E = weightage of equity in D:E

B.1.3. Market risk premium

The last input for the CAPM is the expected risk premium on the market index. It is the premium that investors demand for investing in an average risk investment option consisting of a welldiversified investment portfolio (say, for example, the index of the Bombay Stock Exchange Sensex, or that of the National Stock Exchange Nifty) as compared to a risk-free investment option such as sovereign securities.

The risk premium used in the CAPM is often based upon historical data and the market premium is the difference between the average returns on stocks (Rm) and the average returns on risk free securities (Rf) over the measured period (viz., Rm Rf). Again, this risk premium in turn affects the WACC, which is utilized to discount the future FCFFs. Hence, it is imperative that the risk premium reflects a futuristic view, in case it is expected to be different from the historical view.

The length of the measurement period is significant, as the risk premium, and in turn the valuation of the firm, can vary significantly depending upon the time frame considered. In developed

markets like US, measurement periods ranging up to 70 plus years are used for calculating the risk premium. However, in developing countries, such as India, it is difficult to rely on historical data, when and if available, due to volatility in the underlying economy, political instability and underdeveloped capital markets, leading to complexities in the determination of the market risk premium.

As is with any other statistical information, if calculated based on the historical data, the market risk premium is also susceptible to the vagaries of the underlying data points chiefly being the choice of risk free rate of return and the period under consideration in this case. For e.g., as evident from the empirical data included in the table below, the historical U.S. equity risk premium changes considerably depending on: the period interval used to calculate it and the risk-free security used as the base.

Period under consideration

Average returns during the period on Stocks T-Bills 1.02% 3.87% 3.89% 5.99% 4.40% T-Bonds 2.92% 4.79% 5.09% 7.14% 8.14%

Market risk premium during the period on T-Bills 5.47% 6.89% 5.73% 3.90% 4.69% T-Bonds 3.57% 5.96% 4.53% 2.76% 0.95%

1928-1953 1928-1999 1928-2002 1962-2002 1992-2002

6.49% 10.76% 9.62% 9.90% 9.09%

This apart, one has to bear in mind that the required market risk premium to be used to calculate the required return to equity which in turn calculates the WACC is a future expectation and may ignore history if required.

B.1.4. Underlying assumptions for CAPM

As in any financial theory, there are a few underlying assumptions that the CAPM theory is based upon. Some opponents of CAPM argue that these assumptions are invalid in real life, but thats another story. Some of the major assumptions are as under: Perfectly efficient capital markets All investors evaluate portfolios by looking at their expected risk and returns over a oneperiod horizon. All investors have the same one-period horizon All Investors have rational and homogeneous expectations. Hence, given a choice between two otherwise identical portfolio, investors will chose one with o o higher expected return or lower risk

Investible assets are infinitely divisible, hence an individual investor can invest in a fraction of an asset.

Perfect information about markets across all classes of investors. Taxes and transaction costs are immaterial and hence irrelevant.

Each investor can either lend or borrow at the same risk-free rate.

C. Weighted Average Cost of Capital (WACC)

As mentioned above, WACC is the weighted average of the cost of capital of all the providers of finance to the firm. It is calculated simply by assigning weights of the various forms of capital (debt, equity) with their respective costs. However, it is to be noted that the weights assigned are not dependent on the book values, but the respective market values of the various forms of capital.

WACC =

cost of debt (Kd) market value of debt

cost of equity (Ke) market value of equity

Summary

This article is but a simplistic summary of a significant part of the DCF methodology that many regard as arcane and arduous in practice. Given its limited objective, this article does not

highlight the various problems and practical hurdles faced, as well as their mitigations and way outs, whenever one has to actually calculate the value of any underlying asset.

On the plus side, the DCF methodology, unlike most others, provides a scientific highly approach to valuation, with WACC being its most important component one which has a very high influence over the value so calculated. DCF is a very robust methodology, which can work wonderfully right if the underlying assumptions are reasonable and the application is realistic. Hence, DCF is, without doubt, one of the most respected and universally applied valuation methodologies.

Authored by CA Pratik Singhi, an associate member of the Institute of Chartered Accountants of India, and an alumnus of ICFAI Business School Mumbai. pratiksinghi@gmail.com. He can be reached at

References: 1. Valuation - Measuring & Managing the Value of Companies, McKinsey & Co. 2. Investments, Sharpe, Alexander, Bailey 3. Applied Corporate Finance A Users Manual, Aswath Damodaran 4. Equity Valuation, Dun & Bradstreets Financial Education Services 5. 80 Common and Uncommon Errors in Company Valuation, Pablo Fernndez 6. www.bseindia.com: the official website of the Bombay Stock Exchange. 7. www.nseindia.com: the official website of the Bombay Stock Exchange. 8. http://in.finance.yahoo.com