are you talking about?
WACC is a concept often cited but perhaps under-applied by treasurers.
“WACC are you talking about?” is the question we should be asking ourselves.
How can capital structure be optimised while at the same time maximising debt ratio (with negative rates, even if floored) ? Companies have been cleaning up their act and have slashed their debt levels in recent years, but to the detriment of the dynamic management of their capital structure. However, interest rates remain negative within the eurozone.
A forgotten concept?
It’s sometimes useful to refocus on certain overused concepts in order to clarify their utility and purpose. We’re all familiar with them but we might have forgotten what their point is and how to use them. WACC very much belongs in this category, as all companies want to have a capital structure that’s as efficient as possible in order to facilitate sustainable growth and a sustainable dividend policy. It’s common for international groups to define a target debt ratio (i.e. the “Debt/Equity ratio”, also often known as the “gearing ratio”) in order to limit maximum indebtedness in relation to the reported EBITDA or EBITA level (i.e. operational income before taxes, depreciation and amortization). Even if the rules are made to be bent according to requirements, it’s still essential to define this ratio, as it will serve as the basis for defining the company’s appetite for risk and its resulting transfer price policy. The key question to be asked is whether the capital structure, as defined by Modigliani & Miller, is in line with the level targeted by the company. Does it have a suitable and efficient capital structure and debt versus capital ratio?
There is sometimes room to optimise the gearing level and therefore the structure of a firm’s capital (beyond the cyclicality inherent in any business). It’s here that the level of WACC (i.e. Weighted Average Cost of Capital) comes into play, to help verify that the level of capital and debt for a structure is fully optimised. Admittedly, this is a matter of figures and so doesn’t tell the whole story, in contrast to what we were always taught at university. But this concept is useful nonetheless and deserving of special examination when reviewing a company’s appetite for risk and transfer price policy.
WACC is calculated using the following formula:
WACC = E/(E+D) * Ke + D/(E+D) * Kd (1-T)
The capital cost (i.e. Ke) needs to be calculated using the traditional CAPM (Capital Asset Pricing Model) formula.
Ke = Rf + Beta * (Rm – Rf)
The beta coefficient of a security, which measures its price sensitivity in relation to movement in the market in general, serves to determine the cost of the company’s equity and, on this basis, that of its financial resources, called ”capital cost” (in a broader sense). The historic beta is obtained arithmetically via regression analysis of the security’s profitability rates against that of the market as a whole (represented by indices). The beta is equal to the covariance of the profitability levels of the security and of the market, divided by the variance of the market’s profitability. It’s important to note here that the beta is dependent on several factors including financial structure.
The higher a company’s debt ratio, the more the (fixed) costs raise its sensitivity to the economic situation. However, the “unlevered” beta is used for non-listed companies.
Next, it’s necessary to determine the cost of the debt (ideally as a whole, but this is not so simple in the case of multinational groups with multiple sources of debt). The benchmark would appear to have to be the debt’s cost in the long and medium term.
Once again, everything will depend on the figures and hypotheses used. However, it’s possible to start from realistic data and to try to determine the ideal and optimum level of capital structure. The trick here consists of increasing the debt level to its maximum without penalising the cost of the debt (which should increase with the latter’s level) and the credit rating being affected. So it’s a matter of adjusting the debt slider in order to maximise its level.
The cost of a debt doesn’t always increase automatically with that debt’s amount. There will be thresholds and tiers which, when crossed, may increase the cost or adversely affect the credit rating (i.e. credit rating downgrading) due to the rise in indebtedness. Here too, the amount and the thresholds are key. The key point is therefore knowing how indebted a firm can become on the capital markets or via bank loans without increasing the cost and thereby even reducing the Weighted Average Cost of Capital.
The WACC is dependent on the proportion of debt and as it is less expensive than capital, the higher it is, the better the WACC will be. The knack consists of shrewdly balancing the proportion of both ingredients up to the maximum level, without massively raising the cost of the debt. The capital cost is also dependent on the group’s beta, which is not entirely under its control. Finally, interest rates also affect the interest risk-free rate and the medium-term debt ratios. The size of the delta between one and the other rate will affect the level of WACC.
An economic indicator
This weighted average cost of capital is first and foremost an economic indicator representing the average annual profitability rate desired by the shareholders and all creditors in return for their investment. It measures the company’s capacity to pay a return on the equity entrusted to it by its shareholders. It also constitutes the vital parameter for confirming future investments (by valuing them). This indicator expresses the average cost of the equity and of the company’s external debt, i.e. all of its financial resources for investment purposes. Used to update and evaluate the profitability of an asset, this rate is specific to each company and will depend on the industry, country, activity type, etc. Ideally, the internal profitability rate should be at least superior to the WACC, so that the updated net value is positive and increases the value of the company or generates it. This enables shareholders to assess the investment opportunity and creditors to measure the risk they are taking by granting credit to this company. And it’s hard to argue that this is not the basis for the company’s whole mainspring: to create value for its shareholders.
Valuation of assets using M&A operations
This concept of capital cost is used to select investment projects (to discount cash flows), value assets or carry out ex-post valuations in order to measure the performance of assets. Given the relativity inherent in this type of exercise, it’s important to try to be consistent and coherent in the hypotheses and methodologies used. These concepts need to be mastered but the practical aspect needs to be kept in mind. Poorly handled figures could become time bombs where WACC is concerned. One attractive idea is to share the ideal volume between securities and debts. The theories of Miller & Modigliani start from hypotheses which are not always proven in practice (e.g. perfection of the markets, no transaction cost, borrowing at risk-free rates, etc.). The key point here is simply that a WACC rate which is low (and therefore “optimised”) enables the underlying value to be increased during valuations.
Poorly handled figures
could become time bombs
where WACC is concerned.
Financial theory or economic reality?
The financial theory is one thing; applying it within the economic reality is another. Let’s not forget that the economic context and the post-financial crisis have driven numerous groups to greatly reduce their debt levels and to build up oversized cash reserves. Isn’t this just a case of “once bitten, twice shy”? Despite negative interest rates (although floored to zero), companies are paradoxically borrowing less than before, despite the fact that this would be a good time to optimise their debt structure. The ratings agencies, meanwhile, have a degree of power that is sometimes not compatible with the ideal capital structure (e.g. structural subordination, off balance-sheet restatement of commitments, economic debt including pension obligations, etc.). Assets which could be reinvested in remain at valuation multiples that are much too high. The stock markets are leading the way and everything is exorbitantly priced, which is not encouraging reinvestment. Companies too have already abused share repurchases and jumbo dividends. The time will come when they will have to ask themselves the right questions and follow the recommendations of their treasurers. At the same time, let’s not forget that the latter have worked to improve working capital requirements, thereby reducing indebtedness into the bargain. The alchemy is therefore not as simple as Modigliani stated and, on the ground, a number of factors need to be taken into account. The most recent of these applies to US companies, in the shape of a fiscal reform of the century that will allows the repatriation of funds to the country under enhanced taxation conditions. At the end of the day, these are only figures that we’re trying to bring to life and, sometimes, they are being fiddled with to the point of making them say something we want to hear. With this type of formula, everything will depend on the hypotheses and benchmarks adopted. It’s reasonable to conclude that the theory is not always applicable as such. However, it’s worth keeping in mind the financial principles that should guide our search for the most optimum structure. We need to accept that the economic reality is sometimes very far removed from the best financial principles.
As Mark Twain said: “Truth is stranger than fiction, but it is because fiction is obliged to stick to possibilities, truth isn’t.” Now there’s some food for thought…