Adjustments in WACC
Adjustments in WACC (Weighted Average Cost of Capital) refer to changes made to the components that make up WACC, such as the cost of debt, cost of equity, and the weightings of each component. These adjustments are made to reflect changes in the company's capital structure, risk profile, or market conditions, and are important for accurately determining the cost of capital for investment decisions.
7 Key excerpts on "Adjustments in WACC"
eBook - ePubValue-based financial management
Towards a Systematic Process for Financial Decision - Making
- Maximiliano González Ferrero, Alexander Guzmán Vásquez, María Andrea Trujillo Dávila(Authors)
- 2021(Publication Date)
- CESA(Publisher)
...Chapter 5 Weighted Average Cost of Capital (WACC) T his chapter addresses the topic of how to estimate the weighted average cost of capital (WACC). As discussed in the previous chapters, there are two important ratios to evaluate the performance of companies: the ROIC, which was described in Chapter 3, and the IRR, which was addressed in Chapter 4. It was also pointed out that the IRR on free cash flows is equivalent to the ROIC or OROA but calculated under a dynamic approach and not for one specific year; additionally, it starts from the cash obtained from operations and not from the operating profit after tax. However, these two ratios that reflect what the company is generating in terms of return do not reflect what it should generate in terms of the risk taken by financing providers (debt and equity), nor the investment opportunities available on the market. The WACC is the parameter that allows determining the minimum return the company should deliver to its financing providers. Figure 9 shows the decision-making process that is being described here. Figure 9. WACC As already explained, the WACC or weighted average cost of capital represents the expected return for financing providers, that is, debt and equity. The accounting equation A = D + E indicates that the assets of a company are financed with a ratio of debt and equity. In both cases, both the provider of debt capital and the provider of equity capital must not only face a risk, but also give up other investment opportunities on the market; therefore, they demand to be compensated. If, for example, the company has a high risk of bankruptcy given its high level of indebtedness, the cost of debt, r D, will increase until compensating the financial creditor; on the other hand, if shareholders perceive a high operational and financial risk, the demanded return on the money invested in the firm, r E, will increase accordingly. Although risk is always given a negative connotation, it is not necessarily bad...
eBook - ePub- Robert Irons(Author)
- 2019(Publication Date)
- Routledge(Publisher)
...8 Capital Structure and the WACC Capital structure refers to the mix of debt and equity the firm uses to fund its assets. There are some large firms that use little or no long-term debt, like Facebook (with zero long-term debt 2013–2017), and others that make much more use of debt, like Tesla (with only 15% of their assets funded by equity in 2017). The different sources of funds have different costs and different levels of risk, and firms typically use the mix of debt, preferred equity and common equity that minimizes their weighted average cost of capital (WACC)—the average cost from all sources of funds, weighted according to how much of each source the firm uses to finance its operations. The overall cost the firm pays for the money it raises will be a function of the amount of money raised via each source (the weights of each source in the capital structure) and the required return associated with each source (the component costs of capital). In this chapter, we discuss the sources of funds available to the firm and the methods used to determine the cost of funds from each of those different sources. We will review how to determine the weights for each source of capital used in the capital structure, and then put it all together to calculate the weighted average cost of capital. Since the WACC is used as the discount rate for valuing projects as well as for the CFFA model for valuing the firm, this subject is closely tied to all three of the fundamental principles. The Fundamental Principles in Action FP1 says that the value of an asset is the present value of the cash flows the asset is expected to produce. For production projects, as well as for the free cash flow model for valuing the firm, the present value is calculated using the WACC as the discount rate. FP2 states that risk and return are directly related, and so riskier assets require higher returns...
eBook - ePubThe Capital Budgeting Decision
Economic Analysis of Investment Projects
- Harold Bierman, Jr., Seymour Smidt(Authors)
- 2012(Publication Date)
- Routledge(Publisher)
...The same general approach can be used to compute a project’s cost of capital or a cash flow component’s cost of capital. There is also the question of how the asset’s value is affected by the financial mix decision. The following theories deserve consideration. The value of a firm and the consequent wealth position of the stockholders is not affected by the type of financing. There is an optimum capital structure and the utilization of this structure will maximize the value of the firm. Given the present corporate tax laws, a firm should use as much debt as possible to maximize its value and the wealth position of its stockholders. The use of debt offers a tax advantage but it also increases the expected costs of financial distress. Given the presence of personal taxes as well as corporate taxes, common stock may have tax advantages compared to debt by means of tax deferral as well as preferential treatment of capital gains and dividends. In this chapter we examine and evaluate each of these theories and the role the weighted average cost of capital plays in the capital structure and capital budgeting decisions. The key symbols to be used are: k 0 = the weighted average after-tax cost of capital k i = the before-tax average cost of debt, k i (1− t c) the after-tax cost of debt k e = the after-tax average cost of equity capital B = the market value of the debt in the capital structure S = the market value of the stock equity in the capital structure V = the total market value of the firm: V u is the value of an unlevered firm; V L is the value of a levered firm t c = the corporate tax rate. Definition The weighted average cost of capital (k 0 or WACC) is defined as the sum of the weighted costs of debt (k i) and equity capital (k e), where the weights are the relative importance of each in the firm’s capital structure and the k i and k e costs are the. expected returns required by investors as an inducement to commit funds...
eBook - ePub- Kalpesh Ashar, Vibrant Publishers(Authors)
- 2022(Publication Date)
- Vibrant Publishers(Publisher)
...Then the cost of new common stock is given as: k e = ($1/($20 x (1 – 10%))) + 5% = 0.056 + 5% = 5.6% + 5% = 10.6% As seen above, the cost of new common equity is a little higher than cost of retained earnings due to the additional flotation costs. 3.5 Weighted Average Cost of Capital (WACC) Most companies raise capital through multiple means – debt, preferred stock, and common stock. Hence, if the company wants to calculate its total cost of capital, it would need to calculate the cost of capital of each of these and then arrive at a composite figure, called Weighted Average Cost of Capital or WACC. Depending upon the capital structure of a company, it would assign weights to each form of funding, like 50% debt, 10% preferred stock, and 40% common stock. Then using these weights, the company can calculate its WACC. Below is an example. The cost of capital for each form of capital is given below. We assume that the company does not issue any new common equity. The 40% common stock is in the form of retained earnings. k d = 8% k p = 9% k s = 10% Also consider effective tax rate to be 40%. Now, in order to calculate the WACC we use the following formula: WACC = w d k d (1 – T) + w p k p + w s k s = 50% x 8% (1 – 40%) + 10% x 9% + 40% x 10% = 2.4% + 0.9% + 4% = 7.3% This is the cost of capital that the company would use in capital budgeting to decide whether projects should be taken up or not. This figure is also called a “hurdle rate” that projects need to cross in order to be taken up by the company. In the above example, all projects giving a return of more than 7.3% would be taken up and those returning lesser would be rejected. The above-mentioned hurdle rate applies to projects that are of average risk for the company. But if the company is considering a project that is riskier than its average project, then it would use a hurdle rate that is higher than its WACC. Similarly, for a lower-risk project, it would use a hurdle rate that is lower than its WACC...
eBook - ePub- Clive Marsh(Author)
- 2012(Publication Date)
- Kogan Page(Publisher)
...This can be a subject that occupies the time of academics who spend a lifetime debating and arguing about the pros and cons of each method. Certainly it is an important subject, particularly for very large organizations making decisions that involve billions. However, I shall try to keep this discussion at a practical level and explain what I think will be useful to a practising business manager. First of all we will discuss the two concepts of the average cost of capital and the marginal cost of capital. The weighted average cost of capital (WACC) A company has the following sources of capital: Ordinary shares €300K @ 10 per cent per annum Long-term loans €150K @ 6 per cent per annum Short-term loans €100K @ 8 per cent per annum Total €550K Its weighted average cost of capital is: The marginal cost of capital If we assume that this company wishes to borrow more money but that the only funds currently available in the market for this level of risk are priced at 12 per cent per annum, then the marginal cost of capital is 12 per cent per annum. If additional capital is taken up at this marginal cost, then the weighted average cost of capital will increase. The cost of ordinary share capital We talked above about the costs of share capital and loan capital. Whilst it is easy to determine the cost of loan capital (the agreed rate in the contract) what is the actual cost of share capital or equity? Whilst the directors are under no obligation to make regular dividend payments to ordinary shareholders it must be remembered that these shareholders generally carry the highest risk, own the company and quite rightly expect the highest return. Shareholders will also want to see the market value of their investment maintained or increased. Therefore, the cost of equity is the rate that needs to be paid to maintain shareholder value and to meet their expectations. Example A company earns 10p (after interest) per share and pays a regular dividend of 5p per share...
eBook - ePub- Vibrant Publishers, Kalpesh Ashar(Authors)
- 2019(Publication Date)
- Vibrant Publishers(Publisher)
...Let’s also say that company does not have enough Retained Earnings to satisfy its capital requirements and hence decides to issue new common stock at $20. Due this new stock offer, it would incur a flotation cost, say 10% of its offering of $20. Then the cost of new common stock is given as: k e = ($1/($20 x (1 – 10%))) + 5% = 0.056 + 5% = 5.6% + 5% = 10.6% As seen above, the cost of new common equity is a little higher than cost of retained earnings due to the additional flotation costs. Weighted Average Cost of Capital (WACC) Most companies raise capital through multiple means – debt, preferred stock and common stock. Hence, if the company wants to calculate its total cost of capital, it would need to calculate the cost of capital of each of these and then arrive at a composite figure, called Weighted Average Cost of Capital or WACC. Depending upon the capital structure of a company, it would assign weights to each form of funding, like 50% debt, 10% preferred stock and 40% common stock. Then using these weights, the company can calculate its WACC. Below is an example. Cost of capital for each form of capital is as below. We assume that the company does not issue any new common equity. The 40% common stock is in the form of retained earnings. k d = 8% k p = 9% k s = 10% Also consider effective tax rate to be 40%. Now, in order to calculate the WACC we do the following: WACC = w d k d (1 – T) + w p k p + w s k s = 50% x 8% (1 – 40%) + 10% x 9% + 40% x 10% = 2.4% + 0.9% + 4% = 7.3% This is the cost of capital that the company would use in capital budgeting to decide whether projects should be taken up or not. This figure is also called a “hurdle rate” that projects need to cross in order to be taken up by the company. In the above example, all projects giving a return of more than 7.3% would be taken up and those returning lesser would be rejected. The above-mentioned hurdle rate applies to projects that are of average risk for the company...
eBook - ePubValuation
Measuring and Managing the Value of Companies
- Tim Koller, Marc Goedhart, David Wessels(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
...Distributing the term across the denominator, the result is the following equation: The expression in the denominator is the weighted average cost of capital (WACC) minus the growth in cash flow (g). Therefore, Equation B.1 can be rewritten as: such that: Note how the after-tax cost of debt and the cost of equity are weighted by each security’s market-based weight to enterprise value. This is why you should use market-based values, and not book values, to build the cost of capital. This is also why you should discount free cash flow at the weighted average cost of capital to determine enterprise value. Remember, however, that you can only use a constant WACC when leverage is expected to remain constant (i.e., debt grows as the business grows). 2 Adjusted Present Value To determine enterprise value using adjusted present value, once again start with V = D + E and multiply by a fraction equal to 1. This time, however, do not include the marginal tax rate in the fraction: Following the same process as before, convert each cash flow in the denominator to its present value times its expected return, and divide the fraction by (D + E)/(D + E): Appendix C shows that if the company’s interest tax shields have the same risk as the company’s operating assets (as one would expect when the company maintains a constant capital structure), the fraction’s denominator equals k u, the unlevered cost of equity, minus the growth in cash flow (g). Make this substitution into the previous equation: Next, focus on the numerator. Substitute the definitions of cash flow to debt and cash flow to equity, as we did earlier in this appendix: In this equation, the two interest terms cancel and the two D (g) terms cancel, so simplify by canceling these terms. Also insert T m (Interest) − T m (Interest) into the numerator of the expression: Aggregate reported taxes and the negative expression for T m (Interest) into all-equity taxes...
