Businesses are financed with debt, equity and sometimes, preferred stock. We will not consider preferred stock in this discussion, because few private companies have it. The discount rate for developing MVTC, or Market Value of Total Capital, is called the Weighted Average Cost of Capital (WACC). In this post, we will discuss the concept of the WACC and its use as an investment tool, illustrate how to develop it, and then show how it can be used to develop indications of MVTC.
WACC as an Investment Tool
For illustration purposes, consider a businessman, Mr. Moneybags, who plans to invest in a business deal. He puts up $1 million of equity. He goes to a bank and borrows another $1 million. Now consider that he puts the entire $2 million into a briefcase and takes money when it is time to invest. One half of the money in the briefcase is provided by Mr. Moneybags, the equity investor, while the other half is provided by the lenders. However, once the money is in the briefcase, it is just $2 million of money. The accountants will have to keep score later.
The bankers require a 5% return on their debt, as well as the eventual repayment of the loan. Say that the business owners have a return expectation of 20%. Since the briefcase holds half equity and half debt, the deal, or project that is being considered must provide an expected return of at least 12.5% (20%*.5 + 5%*.5).
Projects having an expected return of less than 12.5% should not be considered by Mr. Moneybags, because the return is less than necessary to compensate both himself for his equity at risk and the debt stakeholders for their risk. Projects with an expected return of 12.5% or more should be considered.
WACC can be used as in investment tool as in the illustration of Mr. Moneybags. It is also the required return used to discount expected Debt-Free Net Cash Flows, i.e., the cash flows available to both equity and debt providers, to the present in Discounted Cash Flow models.
Developing the Weighted Average Cost of Capital
The equity discount rate we developed previously is the first assumption needed for developing the WACC. We replicate the representative equity discount rate build-up here to have all assumptions in one place.
The second assumption necessary to develop the WACC is the after-tax cost of debt. We can develop the after-tax cost of debt as follows. Begin with the estimated pre-tax cost of debt, subtract the estimated taxes (based on an assumed tax rate) and you have the after-tax cost of debt, as illustrated below.
The final assumption in developing the WACC is the portion of equity and debt in the capital structure, or the portion of MVTC that is comprised of equity and the remaining portion that is comprised of debt. For purposes of illustration we will use an allocation of 70% for equity capitalization and 30% for debt capitalization. This allocation is not uncommon in many private companies that utilize leverage, although the appropriate allocation is always a matter of appraiser (or market participant) judgment.
The weights are multiplied by their corresponding equity or after-tax debt rates, and the products are summed to provide the WACC, or Weighted Average Cost of Capital.
Given our assumptions, we see that the 70% allocation to equity and the 30% allocation to debt yields a WACC of 12.4%. Once you know what the components are, the calculations are pretty straightforward. However, know that appraisers and market participants do not always agree on the components!
Now I’m not suggesting that business owners go out and try to build up equity discount rates and the calculate WACCs, but I am suggesting that this short primer should be helpful when you talk to business appraisers or market participants. It is always good to have a basic understanding of the way that the people you may eventually sell to think about value. And business appraisers attempt to mirror that thinking in appraisals.
Using the WACC in Valuation
Recall that the equity discount rate is used to discount expected benefits related to the equity holders of a business, i.e., to net income and/or net cash flow. We looked at how that is derived, even if it may be a bit foreign to many readers. But hang on, because we will get to something that is more intuitively understandable shortly.
The WACC is applicable to what is called Debt-Free Net Cash Flow. This measure is also applicable to the total capital earnings measure that corresponds to net income to equity. This measure is NOPAT, or Net Operating Profit After Taxes. Debt-Free Net Cash Flow is developed similarly to Net Cash Flow to Equity.
The WACC is employed to discount expected Debt-Free Net Cash Flow (and sometimes, NOPAT) to the present. The Gordon Model works with both Net Income (or Net Cash Flow) and with NOPAT (or Debt-Free Net Cash Flow). We use both below to illustrate conceptually.
Recall that we talked about developing a terminal value in a two-stage Discounted Cash Flow Model. Assuming that the forecast for the finite, interim period cash flows is prepared on a debt-free basis, the terminal value can be estimated using the MVTC formula on the right.
The growth rate for developing MVTC is labeled g’ to differentiate it from the growth rate of net income in the equity equation on the left. Levered earnings may grow more rapidly than unlevered earnings. We will talk about expected growth later.
We will show how the WACC is used in actual application in future posts. For now, however, let’s stay with the conceptual. In the next two posts, we will:
- First, we will look conceptually at the historical balance sheet of a company. We will then convert that balance sheet to a market value balance sheet. From the market value balance sheet, we will look at Market Value Added and Market Value of Total Capital. Finally, we will examine the relationship between MVTC and a concept called Enterprise Value.
- Next, we will relate the WACC we have just developed to more familiar earnings concepts like EBIT and EBITDA, and do something I think will be very interesting indeed related to multiples of EBIT and EBITDA.
Until then, be well!