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1APPLIED FINANCE CENTRE
APPLIED FINANCE CENTREFaculty of Business and Econom ics
FTAWebinarWeightedAverageCostofCapital:Part217July,2018
Presentedby:TonyCarltonAssociateProfessor&ProgramDirector,CorporateFinanceMacquarieAppliedFinanceCentre
2APPLIED FINANCE CENTRE
Tony CarltonApplied Finance Centre, Macquarie UniversityAssociate Professor & ProgramDirector, Corporate Finance
Tony is responsible for managing the Corporate Finance stream in the prestigiousMaster of Applied Finance. Prior to joining the Applied Finance Centre Tony had over25 years' experience in the manufacturing, resource and agricultural industries. Hisexperience includes all aspects of corporate finance and strategy, including projectevaluation, strategic portfolio analysis and restructuring, and the development andexecution of growth strategies. He managed a number of large acquisitions anddivestments both in Australia and overseas, and a number of large scale balancesheet restructurings.
In the Masters of Applied Financeprogram, Tony presents the CoreCorporate Finance course, andelective subjects including AdvancedValuation, Managing ShareholderValue and Corporate Fin ancialStrategy. He completed his PhD atMacquarie University in 2015.
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3APPLIED FINANCE CENTRE
ü RecapofPart1
q ChallengesinapplyingWACC(continued)
q WACCandFinancialStrategy
q IssuesinestimatingWACC
q SourcesofinformationforcalculatingWACC
Agenda
Part2
4APPLIED FINANCE CENTRE
WACCmeasuresthereturnsrequiredbyinvestorsinanasset
RecapofPart1
q UsedinDiscountedCashFlow(DCF)valuations
q TheWACCisdeterminedby thecharacteristicsofthecashflowsbeingvalued– primarilyrisk anddebtcapacity
q OperatingFreeCashFlowsdiscountedatWACCtogiveEnterprise (orAsset)Value
q EnterpriseValue =Equity+ Debt
q WhenusingWACC,EquityValueisdeterminedasaResiduali.e.Equity=EnterpriseValue – Debt
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5APPLIED FINANCE CENTRE
WACCmeasuresthereturnsrequiredbyinvestorsinanasset
Where:Re istheCostofEquity forthecashflowsbeingvalued;
Rd istheCostofDebtusuallyestimatedascurrentborrowingrate;
Tisthemarginalcorporatetaxrate,importantbecauseinterestistaxdeductibleandequityisnot.Thismeansthat,forsensibledebtlevels,WACCreducesduetotaxbenefitofinterestdeductions;
D/V isthetargetdebtcapacityofthecashflowsbeingvalued,,whereDisDebtisexpressedaspercentageofEnterpriseValue,V.Targetgearingisexpressedinmarketvalueterms
RecapofPart1
6APPLIED FINANCE CENTRE
CostofEquityiskeyinputintoWACCcalculation
Costof equityisestimatedusingtheCapitalAssetPricingModel
Where:
Re istheCostOfEquity:returnrequiredbyshareholdersallowingfortheriskinessoftheproject;
Rf istheRiskFreeRate:usuallyestimatedascurrentlongtermgovernmentbondyield,ideallytomatchthetermoftheinvestment.
istheinvestment’sBeta.Itmeasuresthesensitivityofaninvestment’sreturnstochangesintheoverallmarket,andisameasureofrelativerisk.AnassetwiththesameriskasthemarkethasaBetaof 1.Thisistheriskthatcannotbeeliminatedbydiversification;
MRPistheMarketRiskPremium,anestimateoftheadditionalreturnsthatinvestorsrequiretoinvestintheoverallmarketcomparedtoinvestinginriskfreeassets(whichhaveaBetaofzero).InAustralia,anMRPof6%ismostcommonlyused.
Re = Rf + β x MRP
RecapofPart1
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7APPLIED FINANCE CENTRE
SampleCalculation:WACCforNewCrest
Input Data Weighted InputtoWACC
TargetGearing 11%
CostofDebtx(1– Taxrate)
6%x(1– 0.30) 4.20% 4.20%x11% 0.46%
CostofEquity 3%+0.73x6.5%
7.75% 7.75%x89% 6.90%
WACC 7.36%
RecapofPart1
8APPLIED FINANCE CENTRE
WACCbasedvaluationsusedinwiderangeofapplications
Application Whichmeans Howused
CapitalAllocation
EquityValuation
Impairment Testing
Performance measurement
RegulatoryPricing
RecapofPart1
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9APPLIED FINANCE CENTRE
Companywidevdivisionalcostofcapital
Company WideCostofCapital
DivisionalCostofCapital
Company widecostofcapitalappliedtoallprojects
WACCcalculatedforeachdivisionorprojectbased,ontheBetaandD/V oftherelevantdivision– valuationsdoneusingthedivisionalcostofcapital
Betaofparentcompanyis usedtocalculateWACCforcompany
Betaofeachdivisionusuallyfoundbyusing‘comparable’or‘pureplays’–listedcompaniessimilartoeachdivisionareusedtoestimateWACC,asifeachdivisionwasaseparatelistedentity
RecapofPart1
10APPLIED FINANCE CENTRE
Companywidehurdleleadstodeclineinqualityofportfolio
ProjectBeta
Return
0
High
High
CompanywideWACC
RiskadjustedRate
Lowriskgoodqualityprojectsthatgetrejected
HighriskpoorqualityprojectsthatgetacceptedA
BCompanywideWACC
doesnotadjustforriskofdifferentassets
RecapofPart1
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11APPLIED FINANCE CENTRE
Companywidevdivisionalcostofcapital- example
Calculatethecostofcapitalforaprospective investmentintheaquacultureindustry.Assumethisinvestmenthasatarget[Debt/Value]ratioof10%;
Step: Result
[1]Findcomparables Threegoodcomparables inAustralia:Tassal,HuonandCleanSeas
[2]Calculatethe‘Ungeared’or‘Asset’Beta
AssetBetais0.59- refernextslide#1.Thisisthesystematicriskoftheassetwithzerodebt
[3]Calculatethe“Geared’or‘equity’Beta,uisng thetargetgearing
Regeared Betais0.63 - referfollowingslide#2.ThisisanEquityBetawithDebt/ValueRatioequalto10%[Note:D/E=10/90]
[4]CalculateWACC ofTargetAsset WACCis6.80% - referfollowingslide #2
RecapofPart1
12APPLIED FINANCE CENTRE
q RecapofPart1
ü ChallengesinapplyingWACC(continued)
q WACCandFinancialStrategy
q IssuesinestimatingWACC
q SourcesofinformationforcalculatingWACC
Agenda
Part2
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13APPLIED FINANCE CENTRE
KeyissuesinusingWACCtosupportdecisionmaking
ChallengesinapplyingWACC (continued)
#1:Companywideversusdivisionalcostofcapital
#2:Costofcapitalandhurdlerates
#3:CostofCapitalandrisk
#4:PosttaxandpretaxWACC
14APPLIED FINANCE CENTRE
RBAsurvey(2015)andDeloittes (2014)findthatnearly90%ofcompaniesusehurdleratesabove10%
3BULLETIN | J U N E Q UA R T E R 2015
FIRMS’ INVESTMENT DECISIONS AND INTEREST RATES
of years it would take for the capital outlay to be returned by the cash flows generated by the project. Although the payback period is intuitive and easy to communicate, it does not take into account the time value of money and ignores cash flows beyond the chosen cut-off date.
Evidence from Australian FirmsA typical firm in the Bank’s liaison program evaluates discretionary capital expenditure by using DCF analysis, and also by considering the payback period as a supporting consideration. This is in line with the evidence from other advanced economies such as the United States and the United Kingdom (see below) and is also in line with earlier survey evidence for Australia. For instance, a survey of Australian firms conducted by academics in 2004 also found that the vast majority of firms used both methods, which, according to other surveys, had become more popular over the preceding decades (Graph 2).
These observations are broadly in line with recent evidence from the Deloitte CFO Survey, which found that nearly 90 per cent of the Australian corporations that responded used hurdle rates exceeding 10 per cent, and around half of the corporations used a hurdle rate exceeding 13 per cent (Deloitte 2014; Graph 3). Liaison contacts reason that the hurdle rate is often set above the cost of capital to account for uncertainty about the cash flow projections. Contacts also note that there is likely to be an optimism bias in these cash flow projections. As a result, setting a hurdle rate above the cost of capital is likely to improve the chances that investments add value to the firm on a risk-adjusted basis.4
Many liaison contacts also report that hurdle rates are not changed very often and in some instances have not been altered for at least several years. These observations are also reflected in the recent survey by Deloitte; two-thirds of corporations indicated their hurdle rate was updated less frequently than their formal review of the WACC, and nearly half reported the level of their hurdle rate was changed ‘very rarely’ (Graph 4). For these firms, changes in
4 Adjusting for risk by using a higher discount rate rather than by probability weighting the cash flows introduces a bias against longer-term projects, since the present value of a longer-dated cash flow is more sensitive to changes in the discount rate.
Graph 2
Discounted cash flow analysis
Liaison contacts indicate that the hurdle rates used to evaluate business investment opportunities are often several percentage points above the WACC. Hurdle rates of around 15 per cent are quite common, though the range of rates reported is relatively wide, from a little less than 10 per cent up to 30 per cent.
Graph 3
0<7 7<10 10<13 13<16 !160
10
20
30
40
%
0
10
20
30
40
%
Hurdle RatesFor investment decisions, share of firms*
Hurdle rates – %
* Excluding firms that do not use a hurdle rateSources: Deloitte CFO Survey; RBA
ChallengesinapplyingWACC: #2
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15APPLIED FINANCE CENTRE
q USFederalReserve (2013)reportthatasampleofUScompanieshaveaveragehurdlerateof14.1%(whenBBByieldswere4%)
q ForUS,Jagannathan etal(2013)findhurdleratesexceedWACCbyupto8%
q Hurdlerateshashardlychangedinprevious10years,inspiteofinterestratedeclines– impliesitisusedasa“ruleofthumb”ratherthanavaluationtool
q Highergrowthfirmshavehigherhurdlerates,andarelesssensitivetointerestratechanges– becausemarginalreturnsarerelativelyattractive
q Investmentplansnotsensitivetochangesininterestrates
Pervasiveroleofhurdlerates
ChallengesinapplyingWACC: #2
16APPLIED FINANCE CENTRE
Pervasiveroleofhurdlerates–OECDfindadeclineinUserCostofCapitalhasnotdrivenuptickinG7capital investment
Source:OECDEconomic Outlook,Vol 2015, Issue1,Chapter3“LiftingInvestmentforHigherSustainable Growth”
ChallengesinapplyingWACC: #2
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17APPLIED FINANCE CENTRE
q Allowanceforoptimism:Ø BuildsingamingØ BiasesagainstlongtermprojectsØ NotsupportedbyevidenceØ Doesitixtheissue?
q Allowanceforrisk:
Ø NobasisforadjustmentØ LosesTransparency
q DesiretoearngreaterthanWACCØ Valuemaximisedbymaximisingvaluecreation(i.e.acceptallpositive
NPVprojects.TryingtomaximiseROICorotherratiosdoesnotmaximiseVALUECREATION
q Ruleofthumbthathasworked
(Dubious)Rationalesforhurdlerates
ChallengesinapplyingWACC: #2
18APPLIED FINANCE CENTRE
q Preservefinancialflexibilitybyavoidinggoingtocapitalmarkets,especiallyformarginalprojects:
Ø Costofaccessingmarketseasilyadds1%- 1.5%torequiredreturn
Ø USsurveyfindsfinanciallyconstrainedcompaniestendtohavelowerhurdlerates
q Allowanceforoptionality:
Ø Decisionrulesforoptionsgrossuprequiredreturnforvolatility,soonlyveryinthemoneyprojectsgetaccepted,othersdelayed
Ø Decisionrulesincorporatingoptionsjustifypremiumof2%- 4%overWACC
q Allowanceforoperationalconstraints– I.E.ITISPRIMARILYAMANAGERIALDEVICERATHERTHANAVALUATIONTOOL
Ø USsurveyfindsthistobemostsignificantexplanation
(Justifiable)Rationalesforhurdlerates
ChallengesinapplyingWACC: #2
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19APPLIED FINANCE CENTRE
TermonGraph Meaning
NPV/Cost NPVofeachprojectcalculatedatit’sriskadjustedcostofcapital,andusingExpected Cash Flows– sotheNPVisalreadyriskadjusted
ProjectSupplySchedule
ProjectsrankedfromhighestNPV/Cost tolowest,andthencumulated.YoucanthenworkoutwhatthemarginalNPV/Costisatvariouscapitalbudgetlevels
NPV/Costafterflotationcosts
ProjectswhichrequireexternalfundingwillhavealowerNPVbecauseoftransactionscostsinvolvedinraisingnewexternalfunds
WACC Projects whichhaveanNPV/Cost=0arejustearningtheirWACC.TheyhaveazeroNPV– neithervaluecreatingordestroying
HurdleRate#1 Thehurdle rate[expressedasminimumNPV/Costratio],whichacceptsall+ve NPVprojectsuptothelimitofthehurdlerate.Thathurdleratecouldbesetonbasisoftheavailabilityofinternalfunding,oranassumedamountof externalequityordebtraising.
Frameworkforthinkingaboutfirmsize,hurdleratesandfundingrequirements– potentialroleforCorporateTreasurer
ChallengesinapplyingWACC: #2
20APPLIED FINANCE CENTRE
Frameworkforthinkingabouthurdlerates
CumulativeCapitalExpenditure
NPV/Cost
00
High
High
ProjectSupply Schedule
WACC
HurdleRate#1
WACC
“ValueMaximising”
Constrained
ChallengesinapplyingWACC: #2
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21APPLIED FINANCE CENTRE
q WACC,whichisbasedonCAPM,incorporatesanasset’ssystematic(orBeta) risk– thisisriskthatcannotbediversifiedawaybyinvestorsand,undertheCAPMmodel,requirescompensation
q Whataboutprojectspecificrisk– technicallyknownasidiosyncraticrisk?
q Two‘competing’solutions:
(i)adjustthediscountratetoincorporateprojectspecificrisk
(ii)incorporateprojectspecificriskintocashflows
q PotentialroleforCorporateTreasurer,whocanbringriskmodellingskills
CostofCapitalandProjectSpecificRisk– thebigdilemma
ChallengesinapplyingWACC: #3
22APPLIED FINANCE CENTRE
CostofCapitalandProjectSpecificRisk– thebigdilemma
AdjustDiscountRate IncorporateintoCashflows
How Increasediscountrateto allowforproject– higherdiscountrateautomaticallylowersvalue– sothereisa‘riskcharge’
Calculate alternativescenarios,andweightbeprobabiliteis toestimate ‘ExpectedValue’
Advantages Simple – justincreasediscountrate
Correctly incorporatesprojectspecificriskintovaluation–allows fordifferentriskprofiles;Transparent – theprocessofthinkingthroughriskscenariosenhancesunderstandingofprojectdynamics
Disadvantages Adjustmentisarbitrary– norealbasisforadjustingrate
Moreeffortrequired
ChallengesinapplyingWACC: #3
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23APPLIED FINANCE CENTRE
Riskandvaluation:needtobuildmoretransparencyintohowwethinkaboutrisk,valueanddecisionmaking
ChallengesinapplyingWACC: #3
• DiscountRateadjustmentsareanimperfectwaytoadjustforrisk
• Incorporatingintocashflowsisachievable– optimistic&pessimisticcasesareastart;distinguishingbetweenmostlikelyandoptimisticcaseisalsoimportant
• MonteCarlosimulationishelpfultooltogenerateriskprofile,expectedcashflowsandriskmetrics
• Whydon’twedevelopriskmetricsforassetvaluations?
• Suggestionsforincorporatingriskprofileintovaluationsandpricing
24APPLIED FINANCE CENTRE
Decisionmakersneedtousetheriskprofile
Deloitte Touche Tohmatsu © 2015 - Optimising project value
NPV’s are typically skewed and too optimistic
6
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
-500 -400 -300 -200 -100 0 100 200 300 400 500 600 700 800 900 1000 1100
Prob
abili
ty
NPV
Most likely
High
Low Base
20% chance of loss
Deloitte Touche Tohmatsu © 2015 - Optimising project value
NPV’s are typically skewed and too optimistic
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0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
-500 -400 -300 -200 -100 0 100 200 300 400 500 600 700 800 900 1000 1100
Pro
bab
ility
NPV
Most likely
High
Low Base
20% chance of loss
ChallengesinapplyingWACC: #3
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25APPLIED FINANCE CENTRE
Mostrequireuseofprobabilitydistributionofvalue,andthereforesomeriskmodelling
Suggestions DefinitionSharpestyleratio EnterpriseValue/𝜎"#MorganStanleyBull&Bearprice BaseCase isprobabilityweighted,usingResidualIncome
valuation;Downside&Upside scenariospublished
Ruback Incorporatesdownsidescenariointoforecasts
Bancel & Tierney[Cash Flow@Risk]
ValueMinimumCashFlow@debtrate+Excess cashflows@CostofEconomic Capital
Deduct Economic CapitalfromValue
Determine Economic Capitaltocoverspecificdownsideanddeductfrom value;Downsidecanbemeasuredintermsofvalueor‘x’yearsahead
ChallengesinapplyingWACC: #3
26APPLIED FINANCE CENTRE
q Pretaxvaluationshouldusepretaxcashflowsatapretaxdiscountrate,andstillgivethesameresult
q Grossingupisdifficult.Simplydividingby(1-T)israrelycorrect:
o Taxpaidrarelyequalsstatutorytaxrateat30%;
o Needtodoagrossupforeachyear;
o CashFlowdifferentbasistoprofitanyway,sogrossingupCashFlowdoesnotmakesense.
ü C
PreTaxvPostTaxValuation
ChallengesinapplyingWACC: #4
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27APPLIED FINANCE CENTRE
PostTaxValuationYears 0 1 2 3OperatingFreeCashFlow 3,887 12,324 16,273TerminalValue 248,448WACC 8.55%TargetValue 221,006
Refertooriginalexample
ValueofPostTaxCashFlowsdiscountedatWACC
PreTaxvPostTaxValuation
ChallengesinapplyingWACC: #4
28APPLIED FINANCE CENTRE
Forapretaxvaluation,needtodiscountpretaxcashflowsatapretaxdiscountrate:
The“wrong”way:
Usea“Grossedup”WACC:
GrossedupWACC =WACC/(1– TaxRate)
=8.55%/(1– 0.3)
=12.21%
PreTaxvPostTaxValuation
ChallengesinapplyingWACC: #4
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29APPLIED FINANCE CENTRE
PreTaxValuation– thewrongway
PreTaxValuationYears 0 1 2 3OperatingFreeCashFlow 3,887 12,324 16,273TaxPaid 1,507 582 (307)PreTaxOperatingFreeCashFlow 5,394 12,906 15,966PreTaxTerminalValue 253,140PreTaxCashFlowsfordiscounting 5,394 12,906 269,106
GrossedUpWACC 12.21%ValueatGrossedupWACC 205,505Error -7.0%
ChallengesinapplyingWACC: #4
30APPLIED FINANCE CENTRE
PreTaxValuation– correctpretaxratecanbebacksolved –butwhybother?
PreTaxValuationYears 0 1 2 3OperatingFreeCashFlow 3,887 12,324 16,273TaxPaid 1,507 582 (307)PreTaxOperatingFreeCashFlow 5,394 12,906 15,966PreTaxTerminalValue 253,140PreTaxCashFlowsfordiscounting 5,394 12,906 269,106
CorrectPreTaxRate 9.44%ValueatGrossedupWACC 221,006 Backsolved – findingtherate
thatgivestheoriginalvalue.Willvarywithproject
characteristics
ChallengesinapplyingWACC: #4
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31APPLIED FINANCE CENTRE
q RecapofPart1
q ChallengesinapplyingWACC(continued)
ü WACCandFinancialStrategy
q IssuesinestimatingWACC
q SourcesofinformationforcalculatingWACC
Agenda
Part2
32APPLIED FINANCE CENTRE
q UnderlyingfinancialstrategyspecifiedbytheWACC- afixedDebt/Value ratio,andaResidualDividendPolicywhichassumespayoutofcashflowstomaintaintargetD/V
q WACCnothelpfultodeterminefinancialstructure
q WACCandassetbasedfinancing
q SituationswhereWACCnotappropriate
WACC andFinancialStructure
WACCmakesveryspecificassumptionsaboutunderlyingfinancialstrategy
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33APPLIED FINANCE CENTRE
Refertooriginalexample
UnderlyingFinancial Strategy
FinancialStrategyUnderlyingWACCValuation
Years 0 1 2 3
AssumedTargetDebt/Value ratio 25% 25% 25% 25%
EstimatedEnterpriseValue@Yearend 221,006 236,016 243,870 248,448
AssumedDebtBalance[EVxTarget D/V] 55,252 59,004 60,968 62,112AssumedEquityValue[EV- DebtBalance] 165,755 177,012 182,903 186,336
$amountofdebtalwaysadjuststomaintaintheTargetD/Vratioovertheforecastperiod
34APPLIED FINANCE CENTRE
Refertooriginalexample
DebtProfileYears 0 1 2 3
OpeningBalance - 55,252 59,004 60,968Plus Drawdown/(Repayment) 55,252 3,752 1,964 1,144Equals ClosingBalance 55,252 59,004 60,968 62,112
InterestPayments 3,315 3,540 3,658Less: InterestTaxShelter [InterestxTaxRate] 995 1,062 1,097Equals AfterTaxInterestPayment - 2,321 2,478 2,561
UnderlyingFinancial Strategy
Sothedebtscheduleandinterestpaymentsarepredetermined
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35APPLIED FINANCE CENTRE
Refertooriginalexample
CashFlowstoEquity[BasedonEV]
Years 0 1 2 3
OperatingFree CashFlow* (221,006) 3,887 12,324 16,273
Plus DebtDrawdown/(Repayment) 55,252 3,752 1,964 1,144
Less AfterTaxInterestPayment 2,321 2,478 2,561
Equals CashFlowtoEquity (165,754) 5,319 11,810 14,857
Plus Valueatendofforecastperiod 186,336
UnderlyingFinancial Strategy
asisthedividendpolicy.Anysurpluscashdistributedtoshareholders
36APPLIED FINANCE CENTRE
WACCnothelpfulfordeterminingcapitalstructureDecidingthetargetmixofdebtandequity– temptingtocalculateWACCatdifferentgearinglevels
Gearing
Rating
HighLow
AAA AA A BBB BB B CCC
%
Interestrate
CostofEquity
WACCAlthoughitdoesalignwith‘optimum’ratingatlowinvestmentgrade,whichisthemostcommon
rating
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37APPLIED FINANCE CENTRE
WACCnothelpfulfordeterminingcapitalstructure
ButWACCisabluntinstrumentforthisdecision,asitcannotincorporateallofthekeyinputsrequired
InputintoDebtvEquityDecision
DoesWACCincorporatethiseffect?
HigherinterestrateasDebtIncreases
Yes
TaxBenefit ofInterestDeductions
Yes,althoughinpresence oftaxlossesitoverstatesthebenefit
CostsofFinancial Distress No,asthisisusuallyreflected inlowercashflows
RiskofLossofGrowthOptionsasDebtIncreases
No,asthisisusuallyreflected inlowercashflows
38APPLIED FINANCE CENTRE
WACCnothelpfulfordeterminingcapitalstructure
ButWACCisabluntinstrumentforthisdecision,asitcannotincorporateallofthekeyinputsrequired(continued)
InputintoDebtvEquityDecision
DoesWACCincorporatethiseffect?
ReducedAgencyCostsfromHigherDebt
No,thisisusuallyreflected inimprovedcashflows
Accessibilitytomarket No,thisisusually drivenbytargetrating
Bettertofocusonanalysisofcashflows,fundingrequirements,needforflexibility, targetriskprofileandtargetrating– butthatisanothertopic!
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39APPLIED FINANCE CENTRE
q Safestapproach– evaluateeachseparatelyandaddtothebasicvaluationusingasimpleWACC:
q Evaluatingalease – dependsonexactnatureoflease:finance,operatingorfullymaintainedoperatinglease;
q KeyInsight– lease cashflowsareanalternativetodebtthereforeevaluateataftertaxdebtrate
WACC andAssetBasedFinancings
WACCusuallyassumesaweightingofDebt&Equity– whataboutassetspecificfinancingsor,indeed,otherstructuredfinancings?
40APPLIED FINANCE CENTRE
LeaseevaluationisdrivenbyevaluatingleasecashflowsatCostofDebt
CASHFLOWSPECIFICATIONFORTHELEASEVBUYDECISIONAssume:3yearfinancing leasewith annualrentalof$1000Capitalcost:$3400with straightlinetaxdepreciation assumedCostofdebtis7%andTaxrateis30%Year 0 1 2 3
Leasepayment 1000 1000 1000
Taxdeduction onleasepayment -300 -300 -300
Depreciationtaxbenefitforegone 340 340 340
Aftertaxcashoutflowforlease 1040 1040 1040
PVatPosttaxdebtrate 2837
Capex savedbyleasing 3400
NetAdvantagetoleasing 563 POSITIVEVALUEIMPLIESLEASEISBEST
Noteinclusion oftaxshelter
anddebtrate
WACC andAssetBasedFinancings
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41APPLIED FINANCE CENTRE
CASHFLOWSPECIFICATIONFORTHELEASEVBUYDECISIONAssume:Samedealexceptitisanoperatinglease Expectedsalvagevalueis$600.WACCis10%Year 0 1 2 3
Leasepayment 1000 1000 1000
Taxdeduction onleasepayment -300 -300 -300
Depreciationtaxbenefitforegone 340 340 340
Aftertaxcashoutflowforlease 1040 1040 1040
PVatPosttaxdebtrate 2837
SalvageValue(after tax) 420
PVofsalvagevalue 316
Capex savedbyleasing 3400
NetAdvantagetoleasing 247 POSITIVEVALUEIMPLIESLEASEISBEST
Salvagevaluediscounted atWACC
WACC andAssetBasedFinancings
42APPLIED FINANCE CENTRE
Evaluationofleasesdependsonnatureoflease– formulaegiveninAppendix
Operatinglease:NETADVANTAGETO(Operating)LEASING=
FinanceLease:NETADVANTAGETO(Finance)LEASING=
InvestmentOutlay
- Present valueofAfterTaxLeasePayments@AfterTaxCostofDebt
- DepreciationTaxShelterForegone@AfterTaxCostofDebt
InvestmentOutlay
- Present valueofAfterTaxLeasePayments@AfterTaxCostofDebt
- DepreciationTaxShelterForegone@AfterTaxCostofDebt
- Present ValueofForegoneAfterTaxSalvageValueatendoflease:SalvageValue@WACC;BookValuexT@Rd(1-T)
WACC andAssetBasedFinancings
22
43APPLIED FINANCE CENTRE
Evaluationofleasesdependsonnatureoflease(cont)
InvestmentOutlay
- Present valueofAfterTaxLeasePayments@AfterTaxCostofDebt
- DepreciationTaxShelterForegone@AfterTaxCostofDebt
- Present ValueofForegoneAfterTaxSalvageValueatendoflease:SalvageValue@WACC;BookValuexT@Rd(1-T)
+ Present ValueofAfterTaxcashflowssavedfrommaintenanceetc,@WACC
FullymaintainedoperatingleaseNETADVANTAGETO(FullyMaintainedOperating)LEASING=
WACC andAssetBasedFinancings
44APPLIED FINANCE CENTRE
WhenisWACCnotappropriate?
Situationswheretheunderlyingassumptionabout financialstrategydoesnotmatch requiresanalternativetoWACC
ViolationofWACCAssumption Response
PrivateEquity investmentsdonotuseaconstantDebt/Value ratio,butusuallynegotiateafixeddebtschedule
UseFlowtoEquity,method wherecashflowsarediscountedatCostofEquity
International investments,structurescomplicatedbymultipletaxrates,anddebtstructuring
UseAdjustedPresentValuemethod,whichdirectlycalculatescosts&benefitsoffinancingstructures.WACChasthefinancingbenefitsembedded intheRd(1-T)term
Infrastructrue &Property Investments–tendnotto useaconstantDebt/Valueratio,butusuallynegotiatea fixeddebtschedule
UseFlowtoEquitymethod,wherecashflowsarediscountedatCostofEquity
23
45APPLIED FINANCE CENTRE
q RecapofPart1
q ChallengesinapplyingWACC(continued)
q WACCandFinancialStrategy
ü IssuesinestimatingWACC
q SourcesofinformationforcalculatingWACC
Agenda
Part2
46APPLIED FINANCE CENTRE
UncertaintyabouteachcomponentofWACCmeansthereisarangeofuncertaintyintheresult
Issues inestimatingWACC
q MarketRiskPremiumdebate– historyvimpliedforward
o RangeinAustraliaisbetween5%- 7%
q EstimatingBeta– especiallyforthinlytradedstocks,andlimitednumberofcomparables,esp inAustralia
o Justifyby fundamentals,notstatistics
o Fundamentalsimplycyclicalityofrevenues,leveloffixedcosts,durationofassets,degreeofgrowthoptions
24
47APPLIED FINANCE CENTRE
UncertaintyabouteachcomponentofWACCmeansthereisarangeofuncertaintyintheresult
Issues inestimatingWACC
q IfandhowtoincorporateimputationcreditsintoWACC,andvaluationgenerally:o Mostcompaniesdonot formallyincorporatefranking
creditsintovaluation;o Likerisk,generallybettertoincorporate intocashflows,
wherethetimingoftaxpaymentscanbebettercalibrated
o Forthosethatdoinclude,anallowanceisthatimputationcreditsareworthapproximately50%ofcorporate taxactuallypaid
48APPLIED FINANCE CENTRE
Exampledemonstratingimputationadjustedvaluation
Issues inestimatingWACC
WACCImputationadjusted
Gamma 0.5CostofEquity 10% 10%CostofDebt 6% 6%TaxRate 0.3 0.15AfterTaxCostofDebt 4.2% 5.1%TargetD/V 25% 25%WACC 8.55% 8.78%
25
49APPLIED FINANCE CENTRE
Exampledemonstratingimputationadjustedvaluation
Issues inestimatingWACC
ReworkedforImputation
OperatingFree cashFlow 5,394 12,906 269,106
Add ImputationCreditValue (753) (291) 154
Terminal Value 2,346
ImputationadjustedOFCF 4,640 12,615 271,605
ImputationadjustedEV $225,961
OriginalE.V. $221,006
50APPLIED FINANCE CENTRE
UncertaintyabouteachcomponentofWACCmeansthereisarangeofuncertaintyintheresult
Issues inestimatingWACC
q Howtoallowforchangesingearingbetweenprojects–deleveraging&releveraging:o RefertoexampleinPart1forexpressionsfordeleveragingand
releveragingo TechnicalissueaboutwhetheranassumptionofDebtBeta=0–
verycommon,butincorrect,assumptionq Isthereasmallstockpremium– premiumincostofequityforsmall
capstockswillresultinlowervaluationso Smallcapstockscommonlyattractahigherdiscountrate,called
smallcappremium– inorderof5%;o Relevantforvaluinglistedsmallcapsandprivatebusinesses,not
usedinprojectevaluation
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q RecapofPart1
q ChallengesinapplyingWACC(continued)
q WACCandFinancialStrategy
q IssuesinestimatingWACC
q SourcesofinformationforcalculatingWACC
Agenda
Part2
52APPLIED FINANCE CENTRE
Widerangeofsourcesofinformationavailable
SourcesofInformationforWACC
Information Source
Usefulgeneral sourcesofinformationonWACC
KPMGAnnualValuationPracticesSurvey;
Independent Expert reportsonM&Atransactions
AustralianEnergyRegulator
Integrated sourcesprovideanoverallWACCresult
Bloomberg;
MarketRiskpremium AustralianEnergyRegulator
IndependentExpertReports
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53APPLIED FINANCE CENTRE
Widerangeofsourcesofinformationavailable
SourcesofInformationforWACC
SourcesforIndividualbuilding blocks
Source
RiskFreeRate RBA:https://www.rba.gov.au/statistics/tables/
Betas Bloomberg
AGSMRiskMeasurementService
DirectcalculationusingCapIQ
Datastream
YahooFinance
54APPLIED FINANCE CENTRE
WACCisakeymetric incorporatefinance,butstillmanyissues,withscopeforcontributionbyCoprorate Treasurer
Conclusions
q Primarily usedinawidevarietyofvaluationapplications
q WACCshould bebasedonassetspecificcharactistics, especially(systematic)riskanddebtcapacity, butcompanywideWACCcommonlyused(incorrectly)
q Italsocompetesagainsttheuseofahurdle rate– moreatool forrationingcapitalandresources
q Incorporating project specific risk– manyaddan(arbitrary) premiumtodiscount rate.Better way--- incorporate project specific risksinto cashflows
q Generallynotappropriate formakingfinancial strategydecisions
q Anumber ofestimation &application issuessuggesthandlewithcare
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55APPLIED FINANCE CENTRE
Summaryofrelevantvaluationformulae
Appendix
56APPLIED FINANCE CENTRE
Threewaysformodellingvaluations,oftenacombination isused
1. Directcalculation
Step#1:CalculatePVofCashFlowforeachyear:Asinglecashflowin‘n’ yearsisworth:
PV=CFn/(1+Discount Rate)n
OR PV=CFn xPVDiscount Factor
WHERE Discount Factor=1/(1+Discount Rate)n
Discount RateiscommonlyWACC
Step#2: ThensumeachyeartogetthetotalPV– thiswhatwedidinExample3:
ModellingforValuation
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57APPLIED FINANCE CENTRE
Threewaysformodellingvaluations,oftenacombination isused
2. Excelformulae
NPV(rate,values….)foraseries of(changing)valuesoverafixedperiodo Rate=DiscountRateorWACCo Valuesiscellreferencesforcashflows:
o Assumesnoblankcells;o ExcludetheTime=0CashFlow[Excelassumescashflowsatendofeach
period];o Assumesequalperiods
PV(rate,nper,pmt)forafixedtermlevelannuityo Nper isnumberof(equal)periodso Pmt isthe(equal)amountoftheannuity
ModellingforValuation
58APPLIED FINANCE CENTRE
Threewaysformodellingvaluations,oftenacombination isused
3. “Shortcut”formulaeCommonformulaeforperpetuities[PART#1]:Levelperpetuity: PV=CFt /WACC
OR PV=CFt xMultiple
WHERE Multiple=1/WACC
Growingperpetuity: PV=CFt+1/(WACC – g)
OR PV=CFt+1 xMultiple
WHERE Multiple=1/(WACC– g)
AND gisgrowthrateinperpetuity
ModellingforValuation
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59APPLIED FINANCE CENTRE
Threewaysformodellingvaluations,oftenacombination isused
3. “Shortcut” formulaeCommonformulaeforfixedtermannuities[PART#2]:FixedTerm(Level)Annuity:
𝑃𝑉 = 𝐶𝐹)*
+,--− *+,--/ *0+,-- 1
FixedTermGrowingAnnuity:
𝑃𝑉 = 𝐶𝐹)0*1
𝑊𝐴𝐶𝐶 − 𝑔−
1𝑊𝐴𝐶𝐶 − 𝑔
𝑥1 + 𝑔 9
1 + 𝑊𝐴𝐶𝐶 9
WHERE‘T’ isthenumber ofyearsforwhichtheannuityoperates, afterwhich cashflowsarezero.
ModellingforValuation
60APPLIED FINANCE CENTRE
Forthosethatlikeformulae!!!
Operatinglease:NETADVANTAGETO(Operating)LEASING=
FinanceLease:NETADVANTAGETO(Finance)LEASING=
Note:theseformulaworkwhenthere arenotaxlosses.Theyneedadjustment inthepresence oftaxlosses
Lease EvaluationFormulae
+I; −<L> − T@L> + T@Dep>[1 + RF 1 − T@ ]>
−EMVK(1 − T@)[1 + WACC]K
K
>Q;
−BVKT@
[1 +RF 1− T@ ]K
+I;−<L>− T@L> + T@Dep>[1 + RF 1 − T@ ]>
K
>Q;