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Title WACC : Definition, Misconception, and Errors

Author Pablo Fernandez

Methodology and Variables Methodology : 2 methods valuing companies by discounted cash flow : 1. Using the expected equity cash flow (ECF) & the required return to equity (Ke). Equation : a. b. 2. Using the free cash flow & WACC.
a. b. c. ]/[

Findings WACC is the rate at which FCF must be discounted. WACC is a weighted average of 2 different magnitudes : - A cost : cost of debt - A required return : required return to equity (Ke) Some Errors in WACC : 1. Using wrong tax rate T to calculate he WACC 2. Calculating the WACC using book values of debt & equity 3. Calculating the WACC assuming a capital structure that is neither the current one nor the forecast 4. The enterprise value (E+D) does not satisfy the time consistency formulae. 5. Considering that WACC / (1T) is reasonable return for the companys stakehoders. 6. Using the wrong formula for the WACC when the value of debt (D) is not equal to its book value (N) 7. Another example by broadcasting company, performed by an investment bank. Valuation has 2 major errors : 1. Wrong calculation of WACC, We need to know the evolution of the equity value & the debt value to calculate

Conclusion & Recomendation WACC (Weighted Average Cost of Capital) is the rate at which Free Cash Flow (FCF) must be discounted to obtain the same result as the valuation using Equity Cash Flow (ECF).

WACC & VTS (Miles;Ezzell, 1985) Value of the levered firm :

Value of unlevered equity :

VTS of prepetuity growing ata rate g:

If debt is adjusted:

(Harris;Pringle,1985)

Critics (+/-) - The researcher dont mention amount of company that used to build this research. Writers should have to look into certain industries when addressing this concerns. - There are many practioners disagree WACC is neither cost with Fernandez about nor required return, WACC doesnt but it is a weighted represent a cost lies average of a cost & a with the providers of required return. So, the capital. Because it can be misleading each provider of if refer to WACC as capital expects a cost of capital. return on capital, thus to provide the return There is 7 errors (interest and, perhaps becaue of not dividends, but remembering certainly growth in definition of WACC. stock value) the firm has to earn enough to There is relationship repay the capital. between WACC & - A bit confused with Value of the tax writers wacc model, shields (VTS). (E*Ke+D*Kd(1t))/(E+D) which is not WACC is discounted showing the weights rate that usually distributed evenly for used in corporate the capital structure finance. since he is dividing the whole equation by Correct calculation (E+D). There is a

(Fernandez,2007) If maintains fixed book-value leverage ratio:

WACC 2. The capital structure 2008 is not valid for calculating the residual value, Because to calculate the PV of FCF growing at 2% using a single rate, a constant debt to equity ratio is needed. Modigalini & Miller said that KTS = Kd, Harris & Pringle said that KTS = Ku There are 2 financing strategies scenarios : 1. Valid for a company that has a preset amount of debt 2. Valid for a company that has a fixed leverage ratio in market value terms (Miles & Ezzels, 1985) & (Arzac & Glosten, 2005) prove that KTS = Kd for tax shields for the first period & Ku thereafter. It is not posible to derive debt policies that consider to Ku in all period. (Fernandez, 2007) values a firm when its debt policy is determinedby a book-value ratio. From his comparation of increases of debt with increases of asstes measured in bookvalue terms and in marketvalueterms, he found that the average & the median of bookvalue correlation coeficcients are higher in book-value terms

of WACC rests on a correct valuation o the tax shields. Value of tax shields depends on companys debt policies. If the debt level is fixed, tax shields should be discounted at the required return of debt. If the leverage ratio is fixed at market value, tax shileds should use MilesEzzell formulae. If company maintains a fixed book-value leverage ratio, tax shields should use developed formulae by Fernandez. -

Relationship of expected value in FCF & ECF (t =1, constant g):

Value of the Equity today (Ke average discounted rate):

Relationship of WACC & VTS: ( )

Variables: D = Value of Debt E = Value of Equity Ebv = Book value of equity ECF = Equity Cash Flow FCF = Free Cash Flow N = Book Value of debt I = Interest Paid PV = Present Value r = Cost of debt

better form which is why wacc called weighted average cost of capital is (E/(E+D))Ke+(D/(E+D)K d(1-t)) this shows that each of weight is distributed properly for each K value. How about preferred stock effects on wacc? This should be represented in the model because a majority of bigger firms do take preferred stock as part of they capital structure. Agree with writers that, correctly measured, wacc is misnamed. It is not a backward looking cost measured, but a forward looking hurdle rate (idetifying which projects increase the market value of the firm)

= Risk-free rate G = Growth rate WACC = Weighted Average Cost of Capital Ke = Required return to levered cost of equity Kd = Required return to debt VTS = Value of the tax shield = Required market risk premium Vu = Value of Equity in theunlevered company Ku = Required return to unlevered equity Sample : United State Companies

than in market value terms.

CRITICAL REVIEW WACC: Definitions, Misconceptions, and Errors Advanced Finance Management

Created by :

Wiendy Puspita Sari (120120110059) Tri Febrianti (120120110061) Mia Ayuning Rarasputri (120120110068) Rr. Doviane Syahputri R (120120110070)

Magister Science Management Economics and Business Faculty University of Padjadjaran 2012