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Banking The WACC
User's Guide
Contents
OVERVIEW 1
WHAT DO INVESTORS REALLY EXPECT? 2
TOWARD A BETTER BETA 6
THE "RISKLESS" RATE 8
COST OF DEBT 9
CAPITAL COSTS & THE GLOBAL PORTFOLIO 11
APPENDIX A – COST OF CAPITAL BY INDUSTRY AND SUB-INDUSTRY 18
APPENDIX B – COST OF CAPITAL BY COUNTRY 19
BIBLIOGRAPHY 20
LIST OF TABLES 21
LIST OF FIGURES 21
STRATEGIC ADVISORY GROUP PUBLICATIONS 21
THE WACC USER'S GUIDE
OVERVIEW
A critical input for The weighted average cost of capital (WACC) is a critical input for evaluating
evaluating both investment decisions - it is typically the discount rate for net present value (NPV)
investments and calculations.1 And it serves as the benchmark for operating performance, relative
operating to the opportunity cost of capital employed, to create value.2
performance
We focus on issues that arise when calculating the cost of capital. While there have
been challenges to the Capital Asset Pricing Model (CAPM), it remains the most
Perceived CAPM practical approach to determine a cost of equity. In fact, many perceived limitations
limitations arise arise from challenges in applying the model. We draw on our research and experience
from application to provide suggestions to deal with two of the primary difficulties in applying CAPM:
challenges
(1) estimating the market risk premium (MRP) for equities; and (2) measuring the
systematic risk, or “beta,” of a company.
We estimate the MRP at about 5%, based on both historical data and forward
looking market data. We provide tools for deriving more reliable estimates of beta,
especially helpful for business units and unlisted companies, but also illiquid stocks
with unreliable betas. Direct regression is the most commonly used approach but
we also employ alternative methodologies such as constructed betas, portfolio betas,
segment regression betas and multi-variable regression betas. We also "normalize"
the riskless rate with a forward view of the capital markets. Table 1 illustrates our
WACC estimates for several sectors.
Table 1 – Cost of Capital By Industry
Power Real Consumer Energy Telecom Industrials Media Financials Healthcare Technology
Estate Institutions3
Industry Rating BBB+ BBB- A- A- BBB+ BBB+ BBB+ AA- BBB+ A-
Credit Spread 1.0 1.2 0.8 0.8 1.0 1.0 1.0 0.6 1.0 0.8
Cost of Debt 5.2 5.4 5.0 5.0 5.2 5.2 5.2 4.8 5.2 5.0
Tax Rate 36 36 36 36 36 36 36 36 36 36
Expected Value 81 81 91 90 86 88 95 97 97 97
A/T Cost of Debt (%) 3.7 3.8 3.4 3.4 3.6 3.6 3.4 3.1 3.4 3.3
% of Enterprise Value 44 43 23 27 34 29 15 10 10 8
Riskless Rate 5 5 5 5 5 5 5 5 5 5
Asset Beta 0.33 0.40 0.64 0.69 0.81 0.79 0.86 0.85 1.01 1.44
Levered Beta 0.49 0.60 0.76 0.86 1.08 1.00 0.96 0.91 1.08 1.53
Market Risk Premium 5 5 5 5 5 5 5 5 5 5
Cost of Equity (%) 7.5 8.0 8.8 9.3 10.4 10.0 9.8 9.6 10.4 12.6
% of Enterprise Value 56 57 77 73 66 71 85 90 90 92
WACC (%) 5.8 6.2 7.6 7.7 8.1 8.1 8.8 8.9 9.7 11.9
SOURCE: UBS Investment Bank, Public Filings, Compustat Bloomberg (March ’05)
Global corporate Our approach to global corporate capital costs quantifies and captures both
capital costs sovereign risk and inflation risk. However, we do recommend that cash flows be
capture both adjusted for the costs and unsystematic risks of global investing, coupled with a
sovereign and more rigorous risk analysis. Given the many opportunities for profitable growth
inflation risk abroad, more reliable estimates of global capital costs can help ensure that
companies will choose to undertake investments that show promise to add value.
1
WACC is a market weighted average, at target leverage, of the cost of after tax debt and equity. Financing
events per se may not reflect changes in financial policy and may not be permanent changes to the capital
structure. Temporary fluctuations in the mix should not affect WACC. We estimate the cost of equity = Rf +
beta x MRP, Rf is the riskless return, Market Risk Premium (MRP) is the expected return premium for bearing
equity market risk over the riskless rate, and beta is the systematic risk of the business relative to the market.
2
Pettit, Justin, and Alisdairi, M.K., “How to Find Your Economic Profits,” UBS Investment Bank, January 2004.
3
The WACC for financial institutions is (generally) simply the cost of equity, as most debt is “funding debt” (not
financing debt) and should be expensed (not capitalized) where the cost of funds is a “cost of goods sold.”
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THE WACC USER'S GUIDE
30
25
20
15
10
5
0
1959 1964 1969 1974 1979 1984 1989 1994 1999 2004
Consistent with changes in relative volatility over the past century, the premium
investors received for stocks relative to bonds fell from over 10% to about 5%.
This drop in the risk premium was attributable not only to a reduction in the level
of stock market risk, but also to an increase in real required returns on bonds.
4
In “The Shrinking Equity Premium,” Jeremy Siegel estimates the equity premium over U.S. government bonds
for the period 1802-1998 to be between 3.5% and 4.7% (using geometric and arithmetic means, respectively).
5
The study is based on monthly returns on the S&P 500 index (which included only 90 stocks before 1957) and on
US Treasury long bonds, from 1926 through 2004. We reran the study using a value-weighted index that included
all NYSE, AMEX and NASDAQ stocks as a market proxy. Because the results were not materially different from
the ones using S&P 500 data, and since S&P 500 returns are easier for practitioners to access, we recommend
using the S&P 500 index as a market proxy.
6
In our study, we used all available historical returns from 1926 through 2004. Because we used 30 years of data
to calculate the trailing averages, the graphs begin in 1958. The same trends emerge when using 10- and 20-
year averaging periods instead of 30 years.
2
THE WACC USER'S GUIDE
7
In “The End of the Business Cycle” (Foreign Affairs, Volume 76 Number 4 (July/August 1997), Steven Weber of
University of California at Berkeley makes a strong case for fundamental structural economic and capital market
changes making observations of events in US history less representative of responses in the future.
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5
0
-5
-10
0 10 20 30 40 50 60 70
Years of History
8
The market risk premium was estimated to be proximate to 5% in various studies. Ibbotson, Roger G., and
Chen, Peng, “Long-Run Stock Returns: Participating in the Real Economy.” Financial Analysts Journal, 59,
88-98. Also see Mayfield, E. Scott, “Estimating the Market Risk Premium.” Journal of Financial Economics,
Volume 73, Issue 3, September 2004.
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emerging markets. And yet, current and future differences in taxes, treatment of
dividends, etc. may make a global market risk premium somewhat premature.
The US market Yet under the forces of globalism and capital market convergence, many experts
may serve as the now suggest that increasingly the US market may serve as the best proxy for a
best proxy for a future global market risk premium.9 The U.S. has the largest economy and the most
global market liquid capital markets. Consequently, the 5% risk premium seems appropriate for
risk premium other markets, after adjusting for differences in tax rates, etc.
Market-Implied Risk Premium
In Figure 4, we benchmark our historically derived market risk premium against the
implied market risk premium of today's market capitalization and earnings, under
different assumptions for future earnings growth and reinvestment.10 While the
Today's market assumption of constant growth is problematic for an individual company, it is more
implies a cost of
appropriate for an analysis of the broader market.
equity of 10%
and MRP of 5% Based on today's market capitalization, depending on assumed future growth rates
and dividend yields, the dividend discount model implies a cost of equity of about
10% and a market risk premium of about 5%, using a riskless rate of 4-5%.
Estimates of long-term sustainable nominal growth rates now range from 5-7%,
consistent with expected inflation of 2-3% and real GDP growth of 3-4%.
Figure 4– Market-Implied Risk Premium Estimates
Growth Rate
0 5% 6% 7% 8%
2.1% 2.2% 3.2% 4.2% 5.3%
Dividend Yield
9
An excellent discussion of globalism and its impact on integrated and integrating capital markets leading both to
falling risk premiums and risk premium convergence is presented by Rene Stulz, “Globalization, Corporate Finance,
and the Cost of Capital,” Journal of Applied Corporate Finance, Vol. 12 No. 3 (Fall 1999).
10
The dividend discount model (Gordon growth model) assumes growth rates remain constant over time. While
this may be problematic on a microeconomic basis, it is more useful on a broader market basis. Solving for cost
of equity, the Gordon growth model can be expressed as Ke=[(Div0/P0)*(1+g)]+g, where Div0 represents the
annual market dividend payments (approximately $185mm at 2/7/2005); P0 is equal to the total market
capitalization of the index ($11.1bn at 2/7/2005); and g is equal to the estimated dividend growth rate.
11
Retention growth assumes historical returns on book equity (i.e., net income/book equity) as a proxy for future
growth rates based on an earnings retention ratio (i.e., 1- dividend payout). This method is an ex-ante approach
to calculating expectations of future growth rates as follows: (Return on Equity) * (Retention Ratio). Damodaran,
Aswath, Investment Valuation, John Wiley & Sons, Inc., 1993.
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5
walk, longer periods can
be employed to provide
0 more data and improve
reliability. If a trend is
-5
evident or sufficient
-10 history is not available,
-10 -5 0 5 10 more data can be derived
Market Returns (%) from the shorter history
with weekly or even
SOURCE: UBS Investment Bank Illustration
daily returns to provide
enough data for a
meaningful regression. Analyze the residuals of a regression by plotting or sorting–
Sort the residuals
on size and plot by
what is not explained by the regression. Re-regressing the interquartile or interdecile
time. Re-regress range of data should provide a similar slope (i.e. beta) but can give a much better
the interquartile or “fit” (i.e. a more statistically significant coefficient of determination). However, if
interdecile range the slope changes, it raises questions around which slope is correct
2. Industry Betas
Many stocks or markets are less liquid or have too little history, potentially leading
to spurious results if the beta is determined overly mechanically. A simple solution
in such cases, as well as for private companies and business units, is to determine a
proxy for systematic risk by calculating an industry beta. The underlying assumption
is that the systematic risk is similar for all businesses in that industry. However, these
approaches can be sensitive to the selection of peers.
a) Simple Mean or Median of Unlevered Beta: A simple mean or median of
pure-play comparable unlevered betas (i.e. asset betas) may serve as a representative
proxy for the company unlevered beta.13 The unlevered beta is then relevered
based on a target capital structure.
12
Potential questions might probe the interpretation and sensibility of the regression coefficients, summary statistics,
and residuals. Sorting the residuals will help you to flag and understand suspect data, as well as to guide your
choices regarding the amount of history and length of the return periods to be used.
13
The asset beta, or unlevered beta, is adjusted to exclude financial risk from the market beta: Unlevered Beta =
D/EV * Debt Beta (1-tax rate) + (1 - D/EV) * Levered Beta. Debt Beta may be estimated from credit spreads or
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THE WACC USER'S GUIDE
b) Portfolio Beta: Where leverage ratios are similar across an entire industry, a
A single regression
portfolio beta may serve as a proxy for a company beta. The portfolio beta is
of cross-sectional
derived from a single regression of cross-sectional returns for all company-market
returns for all
company-market return points. Include as much data as possible to minimize bias from any point.
return points 3. Secondary Regression by Segment
In cases of highly vertically integrated industries (financial services, resource
industries), where there are often only a few pure-play peer companies, a secondary
regression by segment can be employed to determine a pure-play beta. This is
especially helpful for estimating segment, or line-of-business, costs of capital within
integrated industries. The dependent variable is each company’s unlevered beta
while the independent variables are the percentage exposures to different business
A secondary segment (e.g. by revenue, assets, or operating income). For example, Table 2
regression for illustrates the development of an unlevered lumber beta of 0.50, versus the higher
estimating 0.66 for paper products, within the integrated forest products industry.14
segment, or line-
Table 2 – Segment Beta Regression Illustration
of-business capital
Debt Asset Lumber Paper Other
costs in integrated
Company Beta (%) Beta (%) (%) (%)
industries
International Paper 0.99 40 0.70 49 44 7
: : : : : : :
Temple-Inland 1.26 51 0.77 12 57 31
Boise Cascade 1.99 54 0.69 17 36 47
Industry 0.50 0.66 nm
SOURCE: UBS Investment Bank Illustration
4. Constructed Beta
A constructed beta is especially helpful for illiquid stocks where the beta is artificially
A construct for depressed by a low correlation to the market due to extremely low stock liquidity.
where beta is Betas can be constructed as the product of an industry-portfolio correlation
artificially coefficient and a company-specific relative volatility coefficient:
depressed by low
Beta = Correlation Coefficient Ind. x (Volatility Co. / Volatility Market)
market correlation
due to low stock Volatility of market returns may be measured directly from market data, as can a
liquidity correlation coefficient for the industry (Figure 7). If the business is not traded,
relative volatility may be estimated from the standard deviation of changes in
capitalized NOPAT, or EBIT, as a proxy for return volatility.
Figure 7 – Constructed Beta Illustration
10 Market Vol = 21%
Correlation = 69%
Company Vol = 40%
Industry Returns (%)
5
Constructed Beta =
69% x 0.40 / 0.21 = 1.31
0
-5
-10
-10 -5 0 5 10
Returns Volatility
Market Returns (%)
direct regression of market data. The beta for a conglomerate is a weighted average of division betas, based on
each division’s contribution to the firm’s intrinsic value (capitalized operating cash flow may serve as a proxy).
14
While the t-statistics were all highly significant, the “other” beta is clearly not meaningful due to the wide mix of
other segments within which diversified forest products companies operate.
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THE WACC USER'S GUIDE
If operating results, which are generally available on monthly basis, exhibit seasonality
we recommend regressing the percentage change in capitalized NOPAT or EBIT over
the same period last year against respective annual market returns.
5. Multi-Variable Regression Beta
A novel We employ a novel approach for “hybrid” businesses that share the characteristics of
approach for multiple sectors. For example, a privately owned industrial biotechnology company
businesses that shares specialty chemicals, pharmaceuticals and biotechnology characteristics. Our
share the multivariable regression incorporates valuable, company-specific data found to be
characteristics related to different degrees of systematic risk (Table 3).
of many sectors
Table 3 – Multivariate Regression Beta Illustration
Asset Sales R&D/ NOPAT/ Sales/
Company Beta ln(Capital) Growth (%) Sales (%) Sales (%) Capital (x)
Alza 1.33 14.3 25 7 30 0.67
Dow 0.90 16.9 (1) 4 13 0.93
: : : : : : :
Eli Lilly 1.16 16.4 9 16 25 0.57
Hybrid Co. 1.49 10.0 25 15 25 1.50
SOURCE: UBS Investment Bank Illustration
Our regression predicts an asset beta of 1.49 based on the company’s key drivers
(size, growth, R&D, margins, and capital turns) relative to those of publicly traded
pharmaceutical, biotechnology, and specialty chemicals companies.15
THE "RISKLESS" RATE
With the 10-year With the 10-year Treasury at "abnormally" low levels, we typically "normalize" the
Treasury at riskless rate.16 At the time of writing, 10-year Treasuries were about 4% while the
"abnormally" 10-year historical average was 5.4% and 30-year Treasuries were near 5%. Figure
low levels, the 8 shows the forward curve for 10-year Treasuries - a market-derived estimate for
forward curve the riskless rate - with an asymptote in the 5% range. As an alternative to historical
provides a more
averaging, the forward curve is less sensitive to the choice of period, and provides a
stable, objective
stable and objective benchmark for a normalized riskless rate (Figure 8).
benchmark for a
"normalized" Figure 8 - Historical 10-Year Treasury Rates vs. Forward Rates
riskless rate
8 10-Year Treasury Forward Curve
10-Yr. Treasury Yield
6 FWD Rate = 5%
4
(%)
15
We found significant and intuitively appealing coefficients with this model: 0.214 x sales growth + 0.687 x
R&D/sales–0.205 x sales/capital–0.081 x ln(capital) + 0.394 x net operating profit after tax (NOPAT) margin +
2.348 (intercept).
16
In practice, investors use as a proxy for the risk-free rate any number of government bond rates, each with its
own strengths and weaknesses. Those who use T-bill rates argue that the shorter duration and lower correlation
of the T-bill with the stock market make it truly riskless. However, because T-bill rates are more susceptible to
supply/demand swings, central bank intervention, and yield curve inversions, T-bills provide a less reliable
estimate of long-term inflation expectations and do not reflect the return required for holding a long-term asset.
For valuation, long-term forecasts, and capital budgeting decisions, the most appropriate risk-free rate is derived
from longer-term government bonds. They capture long-term inflation expectations, are less volatile and subject
to market movements, and are priced in a liquid market. See Bruner, Eades, Harris and Higgins, “Best Practices
in Estimating the Cost of Capital: Survey and Synthesis,” Financial Practice and Education, Spring/Summer 1998.
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COST OF DEBT
WACC is calculated using the marginal cost of corporate debt – i.e. the yield the
We also
"normalize" company would incur for borrowing an additional dollar. Credit quality and
credit spreads corporate bond ratings are the primary determinants of the cost of debt, and are
for financial influenced by factors such as size, industry, leverage, cash flow and coverage,
policy purposes profitability, and numerous qualitative factors (Figure 9).17
Interest expense is not an accurate reflection of a corporation’s true cost of debt.
The average coupon currently paid by a corporation is the result of yields and credit
rating at the times of issuance, and may not reflect the market environment or
corporate credit quality. Nor is it a marginal cost.
Figure 9 – The Costs of Debt
Average 10-Year Spread 10-Year Treasury Rate Current Spreads 9.5
10
8.5
7.5 7.9
8 7.1
Cost of Debt (%)
6.6
5.4 5.5 5.7
6 4.9 5.0 5.1 5.3
4.8
0.6 0.7 0.8 0.9 1.1 1.2 1.3 1.5 2.4 2.9 3.3 3.7 4.3 5.3
4
2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2 4.2
-
AAA
AA
A+
A-
BBB+
BBB
BBB-
BB+
BB
BB-
B+
B-
SOURCE: Bloomberg (March ’05)
Finally, the WACC calculation is based on an after tax cost of debt. However,
Higher higher degrees of financial leverage and cash flow volatility will lead to lower
financial expected values for each dollar of tax shield. There will be less profits to shield, a
leverage and loss in time value from loss carry forwards, and an increased risk of financial distress.
cash flow
volatility Table 4 – Expected Value Tax Shield Estimation
lowers the Annual Volatility of Stock Returns (%)
expected value 20 30 35 40 45 50 60
of tax shield 10 100% 100% 99% 97% 93% 89% 79%
Enterprise Value (%)
17
Please refer to Pettit, Justin, Orlov, Serguei and Kalsekar, Ashwin, “The New World of Credit Ratings,” UBS
Investment Bank, September 2004.
18
At the debt's maturity equity-holders can "put" the firm assets to debt-holders in exchange for the face value of
debt (in bankruptcy the debt is effectively forgiven when debt-holders take possession of the assets). However,
if the Company's assets' value declines below the face value of its debt, the bondholders suffer a loss.
19
From the Put-Call parity we derive the probability that a firm will not be able to make a payment on its debt
obligations and thus will not realize a tax shield (G). S–Call (S) = PV (Strike Price @ Rf) – Put (S), where S is the
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THE WACC USER'S GUIDE
Hybrid Instruments
Convertibles offer Convertibles can offer issuers significant tax advantages while minimizing cash
significant tax servicing costs via amortization of the warrant value. WACC estimations are
advantages while complicated by the introduction of hybrids into the capital structure. This is most
minimizing cash easily resolved through an effective bifurcation of the instrument's value into debt
servicing costs via and equity to reflect the true target debt-equity mix (Table 5). However, for ratings
amortization of
agency purposes, cash-pay converts are typically treated as debt until conversion.
the warrant value
This is true regardless of how "in-the-money" they become. Some hybrids, such as
mandatory convertibles, do receive some equity credit for ratings purposes.20
Table 5 – Anatomy of a Convertible Illustration
NC First Put 5
Share Price 30.00
Exercise Price Premium (%)21 33.3
Option Term in Years 19 5
Equity Portion Risk-Free Rate (%) 22 3.9
Equity Volatility (%) 19 35
Warrant Value ($) 23 5.0
Number of Warrants/Bonds 25.0
Warrant Portion Value ($) 23 124
assets of the firm, Call (S) is the value of Equity, PV (Strike Price @ Rf) is the value of riskless debt (Df), PV (Strike
Price @ Rf) – Put (S) is the value of risky Debt (Dr). Hence, Assets – Equity = Risky Debt. Dr/Df = (PV (Strike Price
@ Rf) – Put (S))/PV (Strike Price. @ Rf) = 1–Put (S)/PV (Strike Price @ Rf) = G. Key inputs in the option valuation
are time to maturity and volatility of returns of the underlying asset, in this case the Enterprise Value. We
calculate the later number as the volatility of a market value-weighted portfolio of equity and debt.
20
Refer to Moody’s Rating Methodology Handbook, April 2003; S&P’s Corporate Ratings Critera, 2003; Fitch’s
Corporate Ratings Methodology, June 2003.
21
Exercise Price Premium= (Strike Price/Share Price) – 1
22
Risk-Free Rate = Treasury rate with a tenor matching the option term in years; Discount Rate (%) = Average
“BBB-“ 10-year corporate bond yields
23
Warrant Value estimated using Black Scholes option pricing formula; Straight Debt Portion of Total Value = 1-
Warrant Value/ Value of the Convertible Bond; Warrant Beta = Equity Beta*Warrant Beta*Warrant Delta*Share
Price/Warrant Premium (Financial Theory and Corporate Policy, 3rd Ed, T.E. Copeland, FJ. Weston, pp 473-478).
24
Grossed up Yield = Convertible Yield/Debt Portion of Total Value
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25
Ian Cooper and Evi Kaplanis, "Home Bias in Equity Portfolios and the Cost of Capital for Multinational Firms,"
Journal of Applied Corporate Finance, Volume 8 Number 3 (Fall 1995).
26
Global diversification is a strategy to cope with economic exposures that market integration and risk
management were supposed to eliminate, but did not. Dennis E. Logue, "When Theory Fails: Globalization as a
Response to the (Hostile) Market for Foreign Exchange," Journal of Applied Corporate Finance, Volume 8
Number 3 (Fall 1995).
27
The global CAPM and application to Nestle is outlined by Rene M. Stulz, "Globalization of Capital Markets and
the Cost of Capital: The Case of Nestle," Journal of Applied Corporate Finance, Volume 8 Number 3 (Fall 1995).
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29
Systematic risk, or market risk, stems from economy-wide perils that affect all businesses – by definition this would
include the currency and sovereign risks of the economy itself. What matters to the well-diversified corporation,
and ultimately the well-diversified investor, is any incremental contribution to risk, Modern Corporate Finance, Alan
C. Shapiro (1990) pp. 239-268.
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Instead of raising the cost of capital, project and business operating cash flows
should be adjusted downward to reflect the incremental risks, costs and
uncertainties. Where capital must be rationed, we recommend a ranking to
produce the largest incremental NPV available. The limitation to any “ranking” of
investments is that this must be done in a static environment with all investment
opportunities available for evaluation at the same time – this is rarely realistic.
And capital is very rarely in short supply – investors are clamoring for opportunity.
The greatest constraint, and one of the greatest strategic challenges facing publicly
traded corporations, is opportunity for growth. Stock prices routinely reflect
Excessive hurdle
expectations of tremendous growth. At the time of writing, only 53% of the S&P
rates impede
enterprise value could be justified by the present value of current cash flows
growth and
ultimately require capitalized as perpetuity. A full 47% of the market capitalization was predicated on
large offsetting profitable growth over and above today's level of cash flows.
acquisitions Today's corporate financial policies and practices are at odds with this growth
imperative – excessive hurdle rates impede growth – especially organic growth and
smaller investments (the least amount of risk) and ultimately necessitate large
acquisitions (where risk is greatest) to supplement modest growth.32
30
Capital is "free" because once negotiated it is a sunk cost to operating managers. Thus, in most cases, capital
must be rationed precisely because it is free. If it carries a capital charge, it becomes plentiful, but expensive.
31
See Leaman, Rick, Neissa, Jimmy, Pettit, Justin, et al., “Renewing Growth: M&A Fact & Fallacy,” UBS Investment
Bank, June 2003
32
See Leaman, Rick, Neissa, Jimmy, Pettit, Justin, et al., “Where M&A Pays: Who Wins & How?” UBS Investment
Bank, December 2004
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Systematic Risks
We identify the systematic risks to discrete foreign direct investments that can be
quantified and treated within the cost of capital framework to manage better the
MNC portfolio. However, these risks do not need to be incorporated with arbitrary
and excessive risk premiums; rather, they can be addressed more rigorously in a
fairly straightforward manner.
1. Business & Financial Risks
The inherent business and financial risk need not change for foreign direct
investments because a company's core business and target capital structure does
not typically depend on any particular international operations – we would typically
expect these to be applicable worldwide. For example, in industries where operating
profit tends to be more volatile and correlated to the market (e.g. semiconductor
industry), business risk is high. These risks, measured by the company beta, are
already captured in the corporate cost of capital.
2. Expected Inflation
Future cash flows The rate at which prices are expected to increase, inflation risk, measures the
and FX should relative strength of a currency in relation to domestic expected inflation and are
match inflation typically reflected in forward foreign exchange rates. In effect, it represents the risk
expectations in the arising from expected currency devaluation (longer term) due to differentials in long
discount rate run inflation expectations (assumes interest rate parity holds over the longer run).
These risks implied by the relative risk-free rates between countries or from
inflation-linked government bonds, are incorporated into both the cost of debt and
cost of capital calculations. This risk should be clearly distinguished from the short
run cases where parity breaks down – unexpected currency devaluation is a
possibility subsumed by sovereign risk.
3. Sovereign Risk
Sovereign risk is a Sovereign risk is most commonly associated with the risk that a foreign government
broad category of will default on its loans or fail to honor other business commitments due to change
risks unique to the in government or policy. However, sovereign risk is a broad category of risks unique
eco-political to a country's political and economic environments that also include the impact of
environment currency controls, changes in tax or local content laws, quotas and tariffs, and the
sudden imposition of labor or environmental regulation:
♦ Unexpected Devaluation/Inflation: Sharp movements in the relative valuations of
currencies, as in Mexico in 1994, and in Russia and much of Asia in 1998, go
beyond the weakness implied by expected inflation differentials and are
frequently the result of unrealistic currency pegs. Sudden runaway inflation has
been "employed" to help satisfy debt obligations (e.g. Bolivia in the 1980s).
♦ Policy Risk: A host government, due to leadership or policy changes, may renege
on contracts, agreements or approvals, prevent currency conversion, or impede
repatriation. Other examples include sudden large changes in tax laws, local
content laws, quotas and tariffs, and environmental restrictions. For example,
witness the unexpected difficulties faced by both MNC loggers and miners in the
Pacific Northwest in the 1990s as a result of environmental lobbying.
♦ Expropriation: Host government policy may reduce or eliminate ownership of,
control over, or rights to, an investment by an overseas firm. This has happened
in Russia, Cuba, South America, Israel, and many other countries.
♦ War/Civil Disturbance: This includes acts of sabotage or terrorism, damage to
tangible assets, or interference with the ability of the enterprise to operate.
This has been particularly acute in sub-Saharan Africa and the Middle East.
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THE WACC USER'S GUIDE
Multiple sources of Sovereign risks add a premium to the required rate of return for foreign direct
information to investment. One way of estimating the possible size of this premium is to look at
"triangulate" the "insurance premiums" charged by organizations such as the Overseas Private
sovereign risk Investment Corporation (OPIC) and the Multilateral Investment Guarantee Agency
(MIGA), which guarantee foreign investments against some of the risks cited above.
Other market-based methods may be more reliable. We generally employ multiple
sources of information to "triangulate" sovereign risk premiums: USD denominated
(Global Euro and stripped Brady) sovereign debt yields, and where bond yields are
unavailable or appear unreliable, we use the premiums implied by a basket of similarly
rated (S&P country ratings) countries.33 We begin by estimating a domestic cost of
capital and then add sovereign and expected inflation risk premiums.34
Table 7 – Sovereign Risk
Country Sovereign
USD Rating Risk (bps)
Canada AAA 20
Belgium AA+ 50 400
BBB
BB
B
AAA
AA
A
India BB+ 120
Peru BB 310 Sovereign Rating
Turkey BB- 280
Indonesia B+ 280
SOURCE: S&P Global Ratings Handbook, Bloomberg; CreditDelta (March ’05)
Our sovereign risk premiums (Table 7) reflect the “country risk” relative to an AAA
credit such as the US. Developed countries possess very low risk premiums; Canada
and Italy have sovereign risk premiums of 20 and 40 bps respectively. Developing
sovereign risk premiums range from 70 bps for Chile to 3,190 bps for Argentina.35
Point estimates of For example, Chile USD sovereign debt yields 4.9%, and incorporates an incremental
sovereign risk required rate of return to compensate US (or globally diversified) investors for bearing
represent false Chilean sovereign risk. To determine what portion of that 4.9% represents Chilean
precision - they sovereign risk, we effectively subtract the US sovereign yield from the local country
vary widely within sovereign yield (excluding the effect of compounding) to determine the 70 bps
ratings and are sovereign risk premium. And this appears consistent with the country USD rating.
prone to sudden
change But any point estimate of sovereign risk may represent false precision. Sovereign
risk premiums vary widely even within country ratings, and are subject to sudden
change. Figure 12 illustrates the uncertainty of a sovereign risk premium with a
Monte Carlo simulation based on historical sovereign yield data.
33
For the countries that make long-term borrowings predominantly in USD and not in the local currency, we may
use Eurobond yields or the stripped yield of their International/Brady bonds as a basis for USD-based risk free
rates. The stripped yield is the yield on the non-collateralized portion of the bond. For developed countries (and
those others who are able and tend to borrow long-term in the local currency) we may estimate USD based
sovereign yields based on S&P sovereign credit rating of such countries and corporate credit spread matrix.
34
This process is technically a somewhat iterative process, as the "domestic" cost of capital should not reflect the
net incremental risk of the global assets that are already reflected in the company beta. We skip this step where
the impact is not deemed to be material at the corporate level.
35
See Appendix B: Cost of Capital by Country
16
THE WACC USER'S GUIDE
Probability (%)
4
(6.4%)
3
2
1
0
3 4 5 6 7 8 9 10
Sovereign Premium (%)
SOURCE: Credit Delta, UBS Investment Bank Illustration. We assume a lognormal distribution for sovereign risk
with mean 5.2% and standard deviation 1.2% based on weekly yields of LC denominated sovereign debt.
Global Corporate Capital Costs
A helpful way of looking at the cost of capital for foreign countries is in terms of the
marginal impact of the two systematic risk components—sovereign and currency
risk. Calculating foreign WACC in USD involves adding a sovereign risk premium to
the domestic WACC. To calculate foreign WACC in local currency, we also add the
expected inflation premium.36
For example, in the case of Chile (sovereign risk premium 70 bps, inflation risk
premium 10 bps), a company with a domestic WACC of 8% will have a foreign
WACC in USD of roughly 8.7% and a WACC in local currency of about 8.8%.
Table 8 – Global Costs of Capital
Country Sovereign Inflation Risk Local WACC Local WACC
Risk (bps) (bps) in LC (%)37 in USD (%)38
Canada 20 20 8.4 8.2
Belgium 50 -80 7.7 8.5
Portugal 10 -40 7.7 8.1
Italy 40 -40 8.0 8.4
Hong Kong 50 -120 7.3 8.5
Chile 70 10 8.8 8.7
Israel 100 -10 8.9 9.0
Poland 60 40 9.0 8.6
South Africa 190 190 11.8 9.9
Bulgaria 90 110 10.0 8.9
India 120 170 10.9 9.2
Peru 310 50 11.6 11.1
Turkey 280 830 19.1 10.8
Indonesia 280 350 14.3 10.8
SOURCE: S&P Global Ratings Handbook, Bloomberg, UBS Investment Bank Estimates (March ’05)
The local cost of capital in local currency provides local managers with a reference
Ultimately, the frame when forecasts are based on local currency with local inflation expectations
business case, embedded. But, for purposes of evaluating a contemplated investment in Brazil (or,
quality of cash say, a major expansion of its current operations), a local cost of capital in USD (with
flow forecasts, no significant revenue inflation) provides a better basis.
sensitivity analysis,
and strategic risk The cost of capital is an estimation that should be applied with care to avoid any
management will allusions of false precision. And despite its many degrees of freedom, financial
have the greatest planning time and resources are better allocated to other areas. Ultimately, it is
impact on value the business case, quality of cash flow forecasts, sensitivity analysis, and strategic
risk management that will have the greatest impact on value creation.
36
We estimated currency risk from inflation-linked sovereign bonds, or from the difference between using
expected changes in CPI index, LC sovereign bond yields and the implied LC issuer yields based on S&P Country
Rating as well as yield differentials between local currency and USD denominated sovereign yields.
37
Local WACC in USD = Global WACC + Sovereign Risk Premium
38
Local WACC in LC = Local WACC in USD + Inflation Risk Premium
17
THE WACC USER'S GUIDE
Consumer &
Retailing
Wine & Spirits 0.57 0.67 8.4 A 4.9 53 21 93 7.3
Tobacco 0.39 0.55 7.7 BBB+ 5.2 57 39 84 6.1
Personal & Household 0.76 0.89 9.5 A 4.9 46 22 92 8.1
Consumer Durables 0.70 0.87 9.3 BBB 5.2 42 27 90 7.8
Restaurants 0.61 0.68 8.4 BBB+ 5.2 52 14 95 7.7
Retail & Apparel 0.98 1.10 10.5 BBB+ 5.2 51 17 94 9.3
Real Estate 0.40 0.60 8.0 BBB- 5.4 66 43 81 6.2
Estate
Real
Drilling, Equip. & Svcs 0.98 1.08 10.4 BBB+ 5.2 36 14 96 9.4
Oil and Gas 0.71 0.83 9.2 A+ 4.8 32 22 93 7.9
Pipelines 0.39 0.59 8.0 BBB+ 5.2 67 45 80 6.1
Power 0.33 0.49 7.5 BBB+ 5.2 61 44 81 5.8
Power
39
Tax Rate = 36%, Market Risk Premium = 5%, Riskless Rate = 5%, 10 Yr. T-Bond Yield = 4.2%
18
THE WACC USER'S GUIDE
G7
B D F
Germany AAA AAA 0.3 -0.6 -0.3
A C G
Italy AA- AA- 0.4 -0.4 0.0
B D F
Japan AA- AA- 0.0 -2.5 -2.5
A C G
United Kingdom AAA AAA 0.2 1.4 1.6
A E F
Austria AAA AAA 0.3 -0.6 -0.3
B D F
Belgium AA+ AA+ 0.5 -0.8 -0.3
B D F
Czech Republic A- A 1.5 0.0 1.5
European Union
B D F
Denmark AAA AAA 0.4 -0.6 -0.2
A D G
Finland AAA AAA 0.2 -0.6 -0.4
B D F
Greece A A 1.3 0.5 1.8
B D F
Hungary A- A 1.4 1.9 3.3
B D F
Ireland AAA AAA 0.1 -0.4 -0.3
A C G
Netherlands AAA AAA 0.2 -0.5 -0.3
B D F
Poland BBB+ A- 0.6 0.4 1.0
A D G
Portugal AA AA 0.1 -0.4 -0.3
B D F
Spain AAA AAA 0.3 0.4 0.7
B D F
Sweden AAA AAA 0.3 -0.4 -0.1
A D G
Bulgaria BBB- BBB 0.9 1.1 2.0
Europe &
B D F
Israel A- A+ 1.0 -0.1 0.9
Middle
A D G
East
A D G
Chile A AA 0.7 0.1 0.8
Latin
A D G
Colombia BB BBB 3.8 2.6 6.5
A E F
Mexico BBB A 1.4 4.5 6.0
A D G
Peru BB BB+ 3.1 0.5 3.6
A D G
Venezuela SD B 3.6 23.9 28.4
A C G
Australia AAA AAA 0.0 -0.2 -0.2
A C G
China BBB+ BBB+ 0.6 0.8 1.4
A D G
Hong Kong A+ AA- 0.5 -1.2 -0.7
Asia & Africa &
B D F
India BB+ BB+ 1.2 1.7 2.9
B C F
Indonesia B+ BB 2.8 3.5 6.4
Australia
B D F
Malaysia A- A+ 1.0 -0.4 0.6
B D F
New Zealand AA+ AAA 0.4 0.0 0.4
A E F
Philippines BB- BB+ 4.5 4.2 8.9
B D F
Singapore AAA AAA 0.0 -1.0 -1.0
A E F
South Africa BBB A 1.9 1.9 3.8
A E F
South Korea A- A+ 0.7 -0.3 0.4
B D F
Taiwan AA- AA- 0.8 -0.8 0.0
B C F
Thailand BBB+ A 1.7 0.5 2.2
ABCDEFG
Source: S&P Global Ratings Handbook, The Economist, Bloomberg, CreditDelta (March ’05)
A
Sovereign Risk = (1+Sovereign Yield in USD)/(US Treasury Yield)-1
B
Sovereign Risk = (1+Total Risk Premium)/(1+Relative Currency Risk)-1
C
Relative Currency Risk = (1+Sovereign Yield in LC)/(1+ Sovereign Yield in USD) -1
D
Relative Currency Risk = [1+[(Expected Inflation in Sovereign Country)/(1+ Excpected Inflation in US)-1)]. Expectations
of inflation were obtained from either differentials between sovereign inflation linked bond yields and nominal
sovereign bond yields or UBS Investment Bank estimates of future inflation dated 2/12/05
E
Relative Currency Risk = (1+ Total Risk Premium)/(1+ Sovereign Risk)-1
F
Total Risk Premium = (1+ Sovereign Yield in LC)/(1+ US Treasury Yield)-1
G
Total Risk Premium = (1+ Sovereign Risk)*(1+ Relative Currency Risk) - 1
19
THE WACC USER'S GUIDE
BIBLIOGRAPHY
Bruner, Eades, Harris and Higgins. “Best Practices in Estimating the Cost of Capital:
Survey and Synthesis.” Financial Practice and Education. Spring/Summer 1998
Copeland, T.E. and J. Weston. Financial Theory and Corporate Policy. 3rd Edition
Cooper, Ian and Evi Kaplanis. "Home Bias in Equity Portfolios and the Cost of Capital
for Multinational Firms.” Journal of Applied Corporate Finance, Volume 8 Number 3.
Fall 1995
Damodaran, Aswath, Investment Valuation. John Wiley & Sons, Inc., 1996.
Ibbotson, Roger G., and Peng Chen. “Long-Run Stock Returns: Participating in the
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Logue, Dennis E. "When Theory Fails: Globalization as a Response to the (Hostile)
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Mayfield, E. Scott. “Estimating the Market Risk Premium.” Journal of Financial
Economics. Volume 73, Issue 3, September 2004
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Corporate Capital Costs: The Case of Bestfoods.” The Journal of Applied Corporate
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Shapiro, Alan C. Modern Corporate Finance. 1990
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July/August 1997
20
THE WACC USER'S GUIDE
LIST OF TABLES
TABLE 1 – COST OF CAPITAL BY INDUSTRY 1
TABLE 2 – SEGMENT BETA REGRESSION ILLUSTRATION 7
TABLE 3 – MULTIVARIATE REGRESSION BETA ILLUSTRATION 8
TABLE 4 – EXPECTED VALUE TAX SHIELD ESTIMATION 9
TABLE 5 – ANATOMY OF A CONVERTIBLE ILLUSTRATION 10
TABLE 6 - WEIGHTED AVERAGE COST OF A CONVERTIBLE 10
TABLE 7 – SOVEREIGN RISK 16
TABLE 8 – GLOBAL COSTS OF CAPITAL 17
LIST OF FIGURES
FIGURE 1 – CONVERGING VOLATILITIES – STOCKS AND THE LONG BOND 2
FIGURE 2– DECLINING MARKET RISK PREMIUM 4
FIGURE 3 – MARKET RISK PREMIUM DEPENDS ON HOW MUCH HISTORY 4
FIGURE 4– MARKET-IMPLIED RISK PREMIUM ESTIMATES 5
FIGURE 5 – SUSTAINABLE GROWTH ESTIMATES 5
FIGURE 6 – BETA REGRESSION ILLUSTRATION 6
FIGURE 7 – CONSTRUCTED BETA ILLUSTRATION 7
FIGURE 8 - HISTORICAL 10-YEAR TREASURY RATES VS. FORWARD RATES 8
FIGURE 9 – THE COSTS OF DEBT 9
FIGURE 10 – MNC PORTFOLIO ILLUSTRATION 12
FIGURE 11 – COST OF CAPITAL REFLECTS SYSTEMATIC RISKS 13
FIGURE 12– SOVEREIGN RISK PREMIUM SIMULATION 17
21
THE WACC USER'S GUIDE
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