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7.3. The Real-World Problems of WACC Estimation

Given the assumptions of homogenous risk, marginal investment and a stable capital structure, WACC seems an appropriate minimum return criterion for new projects that will hopefully maximise wealth.

However, a company's overall cost of capital is a complex concept, which may include far more than shareholder dividend-growth expectations and fixed rates of debt interest. Moreover, the WACC model assumes that once they are determined, the variables selected for inclusion in the model are correctly defined and will not change. But think about it?

WACC is applied to investment projects that extend over numerous time periods. Thus, its value is likely to change with economic circumstances, thereby invalidating original NPV calculations. A simple problem concerns the estimation of after-tax capital costs determined by an existing tax regime that changes. More complex is the 2008 global financial meltdown, not only with revisions to interest rates but also equity yields and values characterized by markets unwilling to finance the most "blue chip" of firms.

Even if we ignore recent catastrophic events, it is important to realize that at any point in normal economic cycles, the cost of capital and financial mix for individual companies can vary considerably, even within the same sector. Some firms are naturally more risky than others. Different companies may have different capital structures, by accident if not design. As we shall discover, differences in WACC have important consequences for the relative economic performance of companies and wealth creation.

You are asked to evaluate an investment costing £100,000 and yielding £11,500 per annum for the foreseeable future, subject to the constraints that its acceptance will not alter the firm's existing risk-return profile and capital structure:

- Derive and explain WACC as a discount rate if the corporate tax rate is 25 per cent.

- Evaluate the project's viability by applying the NPV decision rule.

- Outline the implications for shareholder wealth.

The following information is available:

(i) Existing Capital Structure (£k at cost)

Ordinary shares (12 million) 12,000

(ii) Ordinary Shares

The current market price (ex div) is £7.00. Forecast total dividends are £6 million, which represent 75 per cent of earnings. Dividends have been growing at an annual compound rate of 5 percent. If new ordinary shares were issued now the costs incurred would represent 25 pence per share and a reduction below market value of 50 pence per share would also be required to ensure full subscription.

(iii) Preference Shares

Despite a par value of £1.00, current trades are only at 43 pence with new issues at 40 pence.

Review Activity

Retained Earnings 4,000

6% Preference shares 2,000

6% Irredeemable Debentures 6,000

(iv) Debentures

£100 loan stock currently priced at £92 would need to be issued at £90 per cent

The derivation of WACC is straightforward using the appropriate capitalisation formulae, incorporating tax and issue costs where appropriate.

- Marginal component costs are defined as follows:

Issue of ordinary shares = (dividend per share / net proceeds of issue) + growth rate = (0.50 / 6.25) + 0.05 = 13%

Retained earnings = dividend yield + growth rate = (0.50 / 7.00) + 0.05 = 12.1%

Preference Shares = dividend per share / net proceeds of issue = 0.06 / 0.40 = 15%

Debentures (post-tax) = [interest per debenture (1 - tax rate)] / net proceeds of issue = 6.00(1 - 0.25) / 90.00 = 5.0%

- WACC is defined by weighting these individual costs by their proportion in the company's existing capital structure and summating the products to arrive at their WACC. One method is to use balance sheet data as follows:

Capital Structure (£ million)

Weight

Component Cost

(%)

Weighted Cost

(%)

Ordinary shares

12

0.50

13.0

6.50

Retained Earnings

4

0.17

12.1

2.06

Preference Shares

2

0.08

15.0

1.20

Debentures

6

0.25

5.0

1.25

Totals

24

1.00

11.01

Weighted Average Cost of Capital: Book Value

However, this approach invites criticism. Although the capital mix will not change, book weights have been applied to component costs when clearly market values consequential upon additions to the capital structure are more appropriate. What is required for new investment is a weighted average of its marginal costs of capital and not historical costs.

Capital Structure (£ million)

Weight

Component Cost

(%)

Weighted Cost

(%)

Ordinary Shares

84.0

0.89

13.0

11.57

Retained Earnings

4

0.04

12.1

0.48

Preference Shares

0.8

0.01

15.0

0.15

Debentures

5.4

0.06

5.0

0.30

Totals

94.2

1.00

12.50

Weighted Average Cost of Capital: Market Value

The substitution of market values for book values in our WACC calculation raises the company's discount rate from 11.01 percent to 12.5 percent.

Project viability is established by applying the NPV decision rule to the project data using the 12.5 per cent WACC based on market values as the cut-off rate. The NPV of the £100k investment yielding £11.5k in perpetuity is given by:

NPV = [(11,500 / 0.125) = £92,000] - £100,000 = (£8,000)

So, the project under-recovers and should be rejected. However, it is worth noting that if we had applied book values to WACC the project would appear acceptable.

NPV = [(11,500 / 0.1101) = £104,450] - £100,000 = £4,450

Even so, you will be in no doubt as to which decision is correct if wealth is to be maximised. Projects must always be evaluated in terms of current investment opportunities foregone. Hence, the market value of capital employed and its corresponding incremental yield are the correct factors to determine a firm's WACC as an overall cut-off rate for investment.

The shareholder wealth implications of the correct accept-reject decision using WACC as a discount rate can be confirmed by analyzing the investment's impact on the equity yield. Using market weights from the previous table, let us first calculate the proportion of equity applied to the investment:

£100,000 (0.890) = £89,000

Next calculate the annual cash return available to the new ordinary shareholders.

Capital Investment £

Capital Cost

%

Investor Return £

Annual Cash Inflow

11,500

Retained Earnings £100,000 x 0.04

4,000

12.1

484

Preference Shares £100,000 x 0.01

1,000

15.0

150

Debentures £100,000 x 0.06

6,000

5.0

300

11,000

934

Ordinary Shares

10,566

Finally, let us reformulate this cash return as a yield on the ordinary share issue associated with the investment.

Project equity yield = £10,566 / £89,000 = 11.87%

Since this is less than the 13 per cent marginal cost of new issues calculated at the outset of our analysis, we can confirm that the investment proposal should be rejected. You may also care to confirm that even if the 12.1 per cent cost of retained earnings were incorporated into the yield calculation to provide a more comprehensive measure of the equity rate (i.e. dividends plus retentions) the overall return would only be 11.88 per cent. Since this too, is lower than the 12.1 per cent yield on shares currently in issue, the project should still be turned down.

7.4. Summary and Conclusions

The previous Activity serves as a timely reminder that to maximise shareholder wealth, efficient financial management should comprise two distinct but inter-related functions.

- The investment decision, which identifies and selects opportunities to maximise expected NPV.

- The finance decision, which identifies potential fund sources required to sustain investment, evaluates the return expected by each and selects the optimum mix that minimizes their combined cost (WACC).

As mentioned earlier, the detailed derivation of an optimal capital structure and minimum WACC is better left to a more advanced treatment of finance. What we have observed, however, is that the issue of lower-cost debt (which incorporates tax relief) rather than equity should reduce WACC and increase corporate value. But it is worth noting that this may only be true up to a point.

One school of thought (the traditional view) states that when debt is introduced into a firm's capital structure it may initially reduce WACC and increase total value. But when shareholders and debt financiers perceive that the gearing level is excessive, the WACC will increase again and value fall. This saucer-shaped WACC plotted against increasing leverage is caused by combining a higher return required on existing equity with higher interest rates on new debt issues to compensate both capital providers for the higher financial risk of their investment. Beyond some minimum point, incremental borrowing will not reduce the WACC. It increases because of the detrimental effect on existing equity prices, thereby increasing shares yields. In turn, this leads to higher marginal costs of debt on further increments of borrowing, resulting in subsequent increases in the cost of all the equity in issue.

A contrary view originally synthesized by Modigliani and Miller (MM) as far back as1958, for which there is considerable empirical support, maintains that WACC and value are constant irrespective of the level of gearing. MM maintain that, just like dividends and retained earnings, equity and debt are also perfect economic substitutes. Any change in the gearing ratio immediately elicits a compensatory change in the cost of equity to counter the change in the level of financial risk.

If you are perplexed don't worry. The dynamics of leverage, like much else in finance, are in total disarray since the 2008 global meltdown. Suffice it to say that, if a firm's capital structure is stable, managerial investment and financing decisions should be inter-related by the overall cost of capital.

In terms of the investment decision, the WACC occupies a pivotal position as an opportunity cost criterion (return) which justifies the finance decision. A company wishing to maximise shareholders' wealth would only deploy funds if their marginal yield at least matched the rates of return its investors can earn elsewhere at commensurate risk.

7.5. Selected Reference

Modigliani, F. and Miller, M.H., "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review, Vol. XLVIII, No.3, June 1958.

 
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