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A WACC Sanity Check

A WACC Sanity Check. Kevin Davis Commonwealth Bank Group Chair of Finance Department of Finance The University of Melbourne. Operating and Financial Risk. Financial arrangements can change value of a business activity Tax shields, agency issues, signalling Equivalently

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A WACC Sanity Check

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  1. A WACC Sanity Check Kevin Davis Commonwealth Bank Group Chair of Finance Department of Finance The University of Melbourne ACCC Forum 2 April 2004

  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 ACCC Forum 2 April 2004

  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) ACCC Forum 2 April 2004

  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? ACCC Forum 2 April 2004

  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 ACCC Forum 2 April 2004

  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” ACCC Forum 2 April 2004

  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 ACCC Forum 2 April 2004

  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 ACCC Forum 2 April 2004

  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 ACCC Forum 2 April 2004

  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 ACCC Forum 2 April 2004

  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. ACCC Forum 2 April 2004

  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. ACCC Forum 2 April 2004

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