Understanding WACC and Debt Considerations for Non-Profit Organizations
This examination delves into the complexities of determining the weighted average cost of capital (WACC) for non-profit organizations like ballet companies and museums. It highlights the challenge of accounting for tax implications and opportunity costs, particularly when these organizations have no debt and no equity. It also discusses investment proposals with substantial debt financing, analyzing the risk and tax implications, and cautioning against unrealistic assumptions. This case study underscores the importance of properly calculating WACC when evaluating project viability in non-profit contexts.
Understanding WACC and Debt Considerations for Non-Profit Organizations
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Presentation Transcript
Example 1 • A not for profit organization such as a ballet company or museum, usually carries no debt. Also, since there are no shareholders, there is no equity outstanding. • How would you go about determining the appropriate weighted average cost of capital for not for profit organizations?
Answer 1 • This focuses on the fact that the firm’s cost of capital is an opportunity cost relative to the riskiness of the firm’s assets. In a world without taxes use the weights of the assets and liabilities of the company. • With taxes it is difficult to determine a correct answer. • Donations to such organizations are tax deductible so does this lower the cost?
Example 2 • According to US law companies do not pay tax on 80% of dividends received from shares held in other firms. Only 20% is taxable. • How much must the price of the share fall on the ex dividend date in order to prevent the holder making arbitrage profits? • Assume the CG and statutory tax rates are both 0.50.
Answer 2 • The arbitrage is buy the day before ex div and sell day after.
Problem 3 • The Azzurri company has a current market value of €1 million. Half of which is debt. Its current weighted cost of capital is 9%. The tax rate is 40%. • The treasurer proposes a new project costing €500.000 financed completely with debt. • It will earn 8,5% on its levered after tax cash flows. • The treasurer argues the project is desirable because it earns more than 5% which is the before tax cost of debt to the firm. • What do you think?
Answer 3 • Need to know the appropriate WACC for project. Should suspect 100% debt financing is unrealistic! • Better to calculate new WACC for firm as a whole with the project included. • Find cost of equity as 15%. • Then reapply • WACC = 0,15*0,33 + 0,05(1-0,4)*0,67 = 6.96% • Project should be accepted as earns more than the new WACC.
3 continued • The reasoning of the treasurer is suspect. • 1. No project has 100% debt capacity. • 2. If the project has same risk as the firm but more debt (and can use all tax shields) then reasonable that the WACC is lower. • However, note we used the same cost of equity in both. What is the impact of increased debt on cost of equity! • Should we instead calculate new cost of equity with stable WACC! • On this analysis the project is not sufficient.
