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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