3.3 WACC and Equity (Share the WACC-iness)

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Из курса от партнера The University of Melbourne

Alternative Approaches to Valuation and Investment

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The University of Melbourne

Alternative Approaches to Valuation and Investment

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Курс 4 из 5 — Specialization Essentials of Corporate Finance

In this course, participants will develop an understanding of the intuitive foundations of asset and investment valuation, and how alternative valuation techniques may be used in practice. This is part of a Specialization in corporate finance created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon). View the MOOC promotional video here: http://tinyurl.com/h75pzt6

Из урока

Using financial statement analysis to measure cost of capital

This week we will explain the logical underpinnings of the Weighted Average Cost of Capital Formula and show how it might be estimated in practice by a firm. We will also consider the many challenges that might be faced in using this approach to estimating hurdle rates and conclude with a warning about the perverse outcomes that might occur if the technique is used in a haphazard manner.

3.0 Using Financial Information to Estimate Cost of Capital (Introduction)1:17

3.1 Foundations of the WACC (Finance is so WACC!)11:36

3.2 WACC and Debt (WACC-Owe!)11:54

3.3 WACC and Equity (Share the WACC-iness)6:43

3.4 Issues with WACC (To WACC or not to WACC..?)9:35

Познакомьтесь с преподавателями

Paul Kofman
Dean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean Pinder
Associate Professor
Faculty of Business and Economics

In this next section together, dealing with the calculation of a firm's WACC,

we're going to concentrate upon the other half of the WACC equation, equity.

So the two elements that we need to get a handle on here,

are ke, the cost of equity capital, and E, market value of equity.

As we'll see, if the company's equity is listed,

then it's going to be a very straightforward process.

Firstly, let's consider ke, the cost of equity capital.

As we saw in the last module of this course,

there's a very well-structured approach encapsulated in the capital asset pricing

model that clearly links discount rates to our measure of systematic risk, beta.

So for Kellogg’s for instance,

we ended up with the cost of equity capital of 7.41% per annum.

Now calculating the market value of equity is even more straight forward when dealing

with a listed firm like Kellogg’s.

As we simply multiply the number of shares on issue by the price per share,

giving us the total market value of equity,

which is what we refer to as the firm's market capitalization.

In this instance, that's $23.42 billion.

So for listed firms, its really straightforward.

But what about if our firm's equity is unlisted?

If our firm's shares are not listed, then we won't be able to directly observe

the way in which the returns for the company co-vary with the market, and

hence we won't be directly estimate the beta for the company.

So what we are going to have to do is be a little bit more creative in our approach.

Specifically, we're going to identify another company that is listed and

that operates in the same industry as our company.

We'll then piggyback off of their measure of systematic risk,

being very careful to make sure that adjustments are made for

differences in systematic risk that might be induced by differences in

strategic choices made by the firm, such as the level of leverage employed.

Let's have a look at why this might be necessary.

You might recall from the previous course in this specialization,

<i>Corporate Financial Decision-Making for Value Creation</i>, that the higher the level

of debt within a company, the greater the variability of return to equity holders.

This effect reflects what we refer to as financial risk.

And from our last module together in this course, we demonstrated that the beta for

a portfolio was simply the weighted average of the betas of the assets

within the portfolio.

Similarly, the beta of a company's assets is the weighted

average of the betas relating to the debt of the company and the company's equity.

Because debt holders have a priority claim over both the cash flows and

the assets of the firm, the market value of debt tends to be much less sensitive

to changes in market wide returns than is the market value of equity.

Or put another way, the beta

of a company's debt would be lower than the beta of that same company's equity.

Indeed, a common assumption made for

firms with investment grade debt is that the company's debt beta is equal to zero.

Well, we're going to make use of that common assumption to firstly de-lever

the listed firm's equity beta.

That is, take out the effective leverage

to arrive at an estimate of the beta of the listed company's assets.

The next step will be to relever up

the unlisted firm's equity to reflect the unlisted firm's level of leverage.

Now let's go through an example to demonstrate how this might

work in practice.

So let's assume that you run an established business, Protecta Ltd.

This firm produces plastic shields for motorcycle helmets.

The shares in your company are not yet listed, but

you have identified another firm, Faceoff Ltd.,

that produces the same sort of product and operates in the same sort of markets.

Now Faceoff is listed in the New York Stock Exchange, and

you estimate that its equity beta is 1.30.

Faceoff Limited has a debt to total value ratio of 0.5,

whereas your own firm has a leverage level of 0.2.

Now intuitively holding everything else constant, this implies that the equity

bata for your own firm should be lower than that of Faceoff Limited,

because of the low level of leverage.

There is then this final assumption concerning the debt betas of both

Faceoff and Protecta in that they can be assumed to both be zero.

Well, let's have a look at how we might use this information to

estimate the beta of Protecta's equity.

So, the first step is to back out the implied beta for Faceoff's assets.

That is, what is our measure of the systematic risk of the company's assets

free of any debt effects?

So, with an equity beta of 1.3, and a ratio of equity to total value of 0.5,

we end up with a beta for Faceoff's assets of 0.65.

Now this is what the beta of the company's equity would be

in the absence of any debt at all in the company's capital structure.

We now use this asset beta to work out what the implied beta is for

Protecta, given its lower level of leverage.

And as we go through this calculation, we end up with an equity beta of 0.8125.

Plugging this number into the capital asset pricing model yields a required

return on equity for our unlisted firm of 7.69% per annum.

This can now be used in our estimation of WACC for our unlisted firm.

So, in summary, in this session we've shown you how the estimation of

the cost of equity capital and the market capitalization of equity is a very,

very straight forward process when the equity is listed.

For firms that are unlisted it gets a little trickier.

But it's still possible to use a proxy company that operates in the same

industry, and is subject to the same pressures and systematic risks.

We use that proxy company to obtain an estimate of the cost of equity capital.

Then the key is when working with that proxy company's data,

that we make adjustments at differing levels of leverage between the two firms.

These adjustments are part of the de-levering and re-levering beta prices.

So, in our next session together, we're going to turn our attention to some of

the pitfalls that might arise when companies employ their weighted average

cost of capital as a discount rate in their evaluation of new project proposals.

Stay tuned.

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