Saturday 18 February 2012

Weight averages cost of capital: errors when calculating WACC


In order to invest in a project or a business unit strategy, a firm needs to raise capital. The capital can be raised from several sources such as equity shares, bonds, and return earning.  However, nothing is free. Finance providers have taken risks when investing money in a company so they require an acceptable return. Shareholders expect a return on their invested money, and bondholders expect an interest payment annually. At a certain level of risk of project, there is a minimum level of required rate of return (WACC). At least, company is expected to pay interest on its borrowing money, pay its shareholders directly as dividends if it cannot make a capital investment, which will increase returns for shareholders. The more risky project is the more required rate of returns is. Therefore, estimating WACC is very important. Calculating WACC correctly is also every significant because WACC is used as a tool to approve or reject projects. If the cost of capital is calculated incorrectly, then we may be approve projects that will reduce benefits to shareholders, or reject projects that could benefit shareholders. However, how does company calculate accurately? Is there any errors when estimating WACC? 

In this case, I only concern about cost of equity and cost of debt. There are many errors when estimating WACC. For example, Fernandez (2004) identified the common errors in a paper entitled “80 Common Errors in Company Valuation“.  I realize that most common errors come from calculating cost of equity. Why? Because the procedure for measuring cost of debt is quite simple and easy. The normal procedure only require a forecast of interest rates for the next few year, the proportion of various classes of debt and the corporate income tax rate (Moffett, 2009). However, it does not mean there is no error when estimating cost of debt. All is about forecasting the future. There is nothing reliable.

To calculate cost of equity, there are two models: Gordon Growth Model and Capital Asset Pricing Model (CAPM). The first error I think is using unsuitable model. For example, Gordon Growth Model is a purely quantitative model, does not take into account qualitative factors such as industry trends and management strategy and relies on a future constant dividends’ growth This drawback makes the model less flexible and suitable when applying in rapidly growing industries with less predictable dividend patterns, such as software or mobile phone. Gordon Growth Model is only useful to use in mature industry with stable and predictable dividend growth pattern like tobacco industry. Nowadays, with the growing rapidly of most industries and economies, Gordon Growth Model is less relevant. Instead of that, CAPM is alternative suitable one. Until now, it still exist the debate around the effectiveness of CAPM. The CAPM is widely known, studied by a large amount of analyst and executives. Most financial directors use it to assess their cost of capital and the reliability of project. However, it faced a lot of disfavour such as Harry Markowitz’s, James Montier’s and Eugene Fama’s studies (Financial times, 2007). In my opinion, nothing is such a perfect thing in such an imperfect world. So, let us choose the most suitable updated model in a particular circumstance.         

 Considering CAPM is the most effective model to estimate cost of equity and WACC. Nevertheless, applying a good theory and model does not mean company will calculate WACC correctly. It depends on how company applies the model into practices. As mention above,   Fernandez (2004) shows an amount of errors when estimating WACC :

·         Wrong risk -free rate used for the valuation

o   Using the historical average of the risk-free rate

o   Using the short-term Government rate

·         Wrong beta used for the valuation

o   Using the historical industry beta, or the average of the betas of similar companies

o   Using the wrong formulae for levering and unlevering the beta

·         Wrong market risk premium used for the valuation

o   The required market risk premium is equal to the historical equity premium.

o   The required market risk premium is equal to zero.

·          Wrong calculation of WACC

o   Wrong definition of WACC.

o   Debt to equity ratio used to calculate the WACC is different than the debt to equity ratio resulting from the valuation.

o   Using discount rates lower than the risk free rate.

o   Using the statutory tax rate, instead of the effective tax rate of the levered company

o   Valuing all the different businesses of a diversified company using the same WACC (same leverage and same Ke).

o   Considering that WACC / (1-T) is a reasonable return for the stakeholders of the company.

o   Using the wrong formula for the WACC when the value of debt is not equal to its book value

o   Calculating the WACC assuming a certain capital structure and deducting the outstanding debt from the enterprise value

o   Calculating the WACC using book values of debt and equity
In conclusion, there are a lot of errors and their effects that firm needs consider when calculate the WACC. However, it cannot avoid all of those errors because the time is continuous changing. Every data can become the past one every time. Company and the analyst can only determine the exactly results of project when it happened. Company can only reduce those things as much as possible. The suggestion is company’s WACC calculation should pass an acceptable test before applying. It is suggested to use “Corporate capital costs: a practitioner’s guide” of Justin Pettit (2005) in order to minimize the required rate of return. 

There is only thing that I consider the most is why never use the book value of equity and debt when estimating the capital structure weight for the WACC (Brigham Daves, 2010).

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