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The weighted average cost of capital: a note on its correct use and interpretation.
Subject:
Interest rates (Study and teaching)
Interest rates (Surveys)
Financial management (Study and teaching)
Financial management (Surveys)
Author:
Colon-De-Armas, Carlos A.
Pub Date:
03/01/2008
Publication:
Name: Review of Business Research Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international Copyright: COPYRIGHT 2008 International Academy of Business and Economics ISSN: 1546-2609
Issue:
Date: March, 2008 Source Volume: 8 Source Issue: 2
Topic:
Event Code: 250 Financial management Computer Subject: Company investment
Product:
Product Code: E561000 Interest Rates; 9915100 Financial Management; 9915500 Financial Systems & Controls

Accession Number:
182406772
Full Text:
ABSTRACT

The concept of the Weighted Average Cost of Capital (WACC), widely discussed in textbooks and courses on Financial Management, is often misunderstood. This note intends to clarify the misconceptions in the interpretation of the WACC, to ascertain the limited opportunities in which it can be really applicable, and to provide a summary of the different courses of action suggested in the literature to estimate the cost of capital in most business applications when the WACC is not the best discount rate to use.

Keywords: Financial Management; Cost of Capital; Capital Budgeting; Investment.

1. INTRODUCTION

The concept of the Weighted Average Cost of Capital (WACC), and its applications, are widely discussed in textbooks on Financial Management and in business schools around the world. At first glance, the widespread attention paid to the WACC in academia would appear to be warranted in light of its ample usage in industry. For instance, in a survey of leading practitioners, including the most senior financial officer of 27 large corporations, the most active financial advisers in mergers and acquisitions, and the best-seller graduate-level textbooks, Bruner et al. (1998) found that the "WACC is the dominant discount rate used in DCF analyses". Similarly, in a survey of the largest 100 firms in the Fortune 500 Industrial Firms listing conducted in 1992, Bierman (1993) reported that 68 of the 74 firms (93%) that responded to the survey used the WACC.

This popularity of the WACC, particularly its formula, has led some to surmise a relation between the WACC and the capital structure of the firm that is not necessarily warranted. Furthermore, evidence of its prevalent use may be indicative that the financial officers of a significant number of corporations may be utilizing the WACC for purposes beyond its true applicability.

The consequences of an improper use of the WACC, particularly as it pertains to the evaluation of capital investments, may be significant, not only for individual corporations, but for the economy as a whole. Since 1998, the annual gross private domestic nonresidential fixed investments in the United States have exceeded $1,000 billions (U.S. Department of Commerce, 2007). Even a small deviation from the proper discount rate used by individual firms to evaluate their investments, could cause a significant variation in this number in future years.

This note is prepared in an attempt to clarify the misconceptions in the interpretation of the WACC, to ascertain the limited opportunities in which it can be really applicable, and to provide a summary of the different courses of action suggested in the literature to estimate the cost of capital in most business applications when the WACC is not the best discount rate to use.

The rest of the article proceeds as follows. Section 2 summarizes the main purposes for which companies need a discount rate. Section 3 presents the formula for the WACC and explains the most common misconception that evolves from it. Section 4 discusses the correct logic behind the WACC. Section 5 lists the limited number of circumstances when the WACC is applicable and Section 6 briefly discusses what to do otherwise. Finally, Section 7 contains some concluding remarks.

2. WHY A DISCOUNT RATE?

Corporations need a cost of capital (also referred to as the required, or hurdle, rate) for, at least, three different purposes: (1) Estimate the value of the firm by calculating the present value of the estimated future cash flows expected from operations; (2) Analyze new investment opportunities by estimating their net present value (NPV); and (3) Evaluate and compensate employees, for example, under the Economic Value Added (EVA[R]) system discussed by Stern, Stewart and Chew (1996).

In general, the WACC is not the discount rate that should be used for these purposes. The extensive attention paid to it in textbooks and business schools, however, very often mislead people to use the WACC for these and other applications where its usage is not appropriate. For instance, Graham and Harvey (2001) reported that 58.8% of the firms surveyed would use a single company-wide discount rate to evaluate projects in an overseas market even under the assumption that they have different risk characteristics. At the same time, however, in an apparent contradictory finding like often times occur in survey studies, 51% of the firms also said they would use a risk-matched discount rate to evaluate projects with different risks. Bierman (1993) indicated that 93% of the companies responding to a survey used their WACC, although 72% also reported using a rate based on the risk or nature of the project. Brounen, de Jong and Koedijk (2004) found that 58.8% of the European firms in their sample use the same discount rate for the entire company when evaluating projects in overseas markets.

3. THE FORMULA AND ITS COMMON MISCONCEPTION

To calculate the WACC, the following familiar formula is used:

[r.sub.A] = [r.sub.d] (1 - t) D/V + [[GAMMA].sub.e] E/V

where,

[r.sub.A] = weighted average cost of capital

[r.sub.d] = cost of debt

t = marginal tax rate

[r.sub.e] = cost of equity

D = amount of debt in capital structure

E = amount of equity in capital structure

V = total value of assets

V = D + E

and V, D, and E should be based on market values.

As is evident from the above formula, the WACC is calculated as an average of the different financing costs of the firm weighted by the proportions of debt and equity in the capital structure. At first glance, this calculation seems to imply that the cost of capital depends on how the firm is financed. This interpretation, however, is not correct. Not only that, but it also is inconsistent with the theory of finance which, ever since Proposition I by Modigliani and Miller (1958), for the most part has concluded that the value of a firm, and its cost of capital, is independent of its capital structure.

Modigliani and Miller (1963), in their famous "correction" paper, revised their earlier conclusions regarding the tax benefit of debt. This benefit, however, is recognized by incorporating the term (1 - t) in the WACC formula. Furthermore, others have expanded the set of factors that help determine the capital structure of the firm by considering aspects such as personal taxes, financial distress, agency costs, and information asymmetry. The most important studies in this literature are summarized by Myers (2001). At this point, however, no widely accepted alternative has been offered to the hypothesis that the value of the firm is independent from its capital structure.

The challenge, therefore, is to reconcile the calculation of the WACC as a weighted average of the cost of the financing sources of the firm, with the fact, consistent with the theory of finance, that the WACC is not, in reality, a function of the capital structure of the firm. In other words, what then is the correct interpretation of the WACC?

4. THE CORRECT LOGIC

The WACC represents an attempt to estimate the rate of return required to invest in the assets of the firm. This concept is highlighted by the fact that the symbol that represents the WACC in its formula is rA, with the subscript A denoting that it is a required rate calculated for the assets, and not for the sources of financing, of the firm.

Since the objective behind the WACC is to calculate a required rate of return for the assets of the firm, it would seem logical that the market-related information of the assets, including their required rates of return, be analyzed instead of the corresponding information of the financing sources. In practice, however, the information regarding the market values of the assets of a firm, and their required rates of return, are not readily available. Thus, the WACC, particularly the formula used to calculate it, represents a practical solution to this problem of not being able to find market-related information regarding the assets of the firm. To that end, it uses the following two facts: (1) The two sides of the balance sheet should add to the same total; and (2) The market-related information is very often easier to find for the financing sources of the firm than for the assets. Viewed in this light, the WACC looks at the right-hand side of the balance sheet as a practical way to assess the left-hand side.

One way in which to visualize this conundrum is to consider a balance sheet of the firm prepared, not according to historical cost, as required by Generally Accepted Accounting Principles (GAAP), but based on market values.

If one were to prepare such a balance sheet, the market values of assets like accounts receivable, inventories, plant, machinery, equipment, and many other assets would be needed. These market values, however, are not often available. By contrast, the market values of the bonds and common stock of a publicly owned firm are easy to obtain. Since the total market value of the debt and equity (D & E) must add to the total market value of the assets (V), to maintain the accounting identity, using the former is a practical way to analyze the market values of the latter. The same can be said about the individual required rates of return, since these also are easier to find for the financing sources of the firm than for the assets. This approach is the logic behind the WACC formula and explains why, even though the intention is to calculate a weighted average of the required rates of return of the different assets of the firm, we calculate instead the weighted average of its financing costs.

5. WHEN IS IT CORRECT TO USE THE WACC?

Given that the WACC is calculated as a weighted average of the costs of the financing sources of the firm only because the corresponding data on the assets of the firm are not available, the WACC is only applicable when the systematic risk, including its financial component, of the assets of the firm is unaltered and when the relation between both sides of the balance sheet is not materially different. Only under these circumstances is it reasonable to use the right-hand side of the balance sheet in lieu of the left-hand side. Otherwise, the use of the WACC as the appropriate discount rate would be unwarranted.

As a result, the use of the WACC is only limited to the following two circumstances: (1) To estimate the value of the entire firm, without changing the asset, or financing, mix; or (2) To evaluate a possible new investment that is similar in risk and composition to the existing assets of the firm (e.g., an expansion of the firm's current business). Otherwise, a different method to obtain the cost of capital should be used.

In a nutshell, regardless of the inordinate amount of attention given to it in textbooks and courses on Financial Management, in practice, the circumstances under which it would make sense to use the WACC are rather limited in scope and number.

6. WHAT TO DO WHEN THE WACC DOES NOT APPLY

Other than the limited situations described in the previous section, the WACC would not be the correct cost of capital, or discount rate, to use. For instance, in a multi-division firm, where each division operates in a different industry, it is very likely that projects evaluated in each division are very different to one another in terms of their systematic risk. The same can be said about the use of EVA[R] in such a setting, in which case the capital charge applied may need to recognize these systematic risk differences. In those cases, a different cost of capital, based on the systematic risk of each division or activity, has been recommended. In practice, however, the implementation of this recommendation is hampered by the fact that, by its very nature, to estimate systematic risk one would need market information, which is not available for the internal segments of multi-division firms.

To address the need to calculate multiple costs of capital within the firm, some authors have advocated a "pure-play" method, in which the beta of a division, unavailable for lack of market information, is estimated based on the information of publicly traded firms with similar operations. This "pure-play" technique has been analyzed by Fuller and Kerr (1981), Myer and Nyerges (1994), among others. Ehrhardt and Bhagwat (1991) and Kaplan and Peterson (1998) refined this process of estimating beta based on the public information of similar firms by allowing the use of information from conglomerates, which typically where excluded from use in the "pure-play" method because their betas encompass multiple industries. Chua, Chang, and Wu (2006), however, found that the "pure-play" method without this refinement works best, and argued that adjusting for capital structure improves the beta estimates.

Furthermore, Hamada (1972) demonstrated that the systematic risk of common stocks, even within the context of Modigliani and Miller (1958, 1963), has a financial leverage component. Based on this result, several authors, including Conine and Tamarkin (1985), recommend adjusting the cost of capital estimated using the "pure-play" procedure for any differences between the leverage of the comparable publicly-traded firms and the division under consideration.

Another procedure that has been offered to address the need to estimate divisional costs of capital based on the systematic risk of each segment of a firm is to estimate betas using accounting, instead of market, information. This accounting approach has been considered by several authors including Gordon and Halpern (1974), and Hill and Stone (1980).

These suggestions regarding the estimation of the cost of capital are based on the fact that firms should not use one unique cost of capital in their operations. Instead, firms should use multiple costs of capital, with each rate reflecting the systematic risk of the projects or divisions being analyzed.

7. CONCLUSION

More than a financing cost, the cost of capital should be interpreted as a required, or minimum, rate of return that assets should be expected to offer before the firm should be willing to invest in them. As such, the cost of capital of an asset depends on its systematic risk, and not on how it is financed.

Since firms usually conduct operations in different lines of business, using one uniform cost of capital like, for example, the WACC, for all assets within a firm is usually wrong. Instead, the cost of capital should vary by projects or divisions. Therefore, regardless of the inordinate attention it receives in textbooks and courses on Financial Management, the WACC is rarely the correct cost of capital rate to use in practical business applications

REFERENCES AND BIBLIOGRAPHY:

Bierman, Harold, Jr., "Capital Budgeting in 1992: A Survey," Financial Management (Letters) Vol. XXII(3), 1993, 24.

Brounen, Dirk, Abe de Jong and Kees Koedijk, "Corporate Finance in Europe: Confronting Theory with Practice," Financial Management Vol. XXXIII(4), 2004, 71-101.

Bruner, Robert F., Kenneth M. Eades, Robert S. Harris and Robert C. Higgins, "Best Practices in Estimating the Cost of Capital: Survey and Synthesis," Financial Practice and Education Vol. VIII(1), 1998, 13-28.

Chua, Jess, Phillip C. Chang and Zhenyu Wu, "The Full-Information Approach for Estimating Divisional Betas: Implementation Issues and Tests," Journal of Applied Finance Vol. XVI(1), 2006, 53-61.

Conine, Thomas E. Jr. and Maurry Tamarkin, "Divisional Cost of Capital Estimation: Adjusting for Leverage," Financial Management Vol. XIV(1), 1985, 54-58.

Ehrhardt, Michael C. and Yatin N. Bhagwat, "A Full-Information Approach for Estimating Divisional Betas," Financial Management Vol. XX(2), 1991, 60-69.

Fuller, Russell J. and Halbert S. Kerr, "Estimating the Divisional Cost of Capital: An Analysis of the Pure-Play Technique," Journal of Finance Vol. XXXVI(5), 1981, 997-1009.

Gordon, Myron J. and Paul J. Halpern, "Cost of Capital for a Division of a Firm," Journal of Finance Vol. XXIX(4), 1974, 1153-1163.

Graham, John R. and Campbell R. Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," Journal of Financial Economics Vol. LX(2/3), 2001, 187-243.

Hamada, Robert S., "The Effect of the Firm's Capital Structure on the Systematic Risk of Common Stocks," Journal of Finance Vol. XXVII(2), 1972, 435-452.

Hill, Ned C. and Bernell K. Stone, "Accounting Betas, Systematic Operating Risk, and Financial Leverage: A Risk-Composition Approach to the Determinants of Systematic Risk," Journal of Financial and Quantitative Analysis Vol. XV(3), 1980, 595-637.

Kaplan, Paul D. and James D. Peterson, "Full-Information Industry Betas," Financial Management Vol. XXVII(2), 1998, 85-93.

Modigliani, Franco and Merton H. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review Vol. XLVIII(3), 1958, 261-297.

--, "Corporate Income Taxes and the Cost of Capital: A Correction," American Economic Review Vol. LIII(3), 1963, 433-443.

Myer, F. C. Neil and Richard T. Nyerges, "Pure-Play Proxies Reexamined," American Business Review Vol. XII(2), 1994, 47-53.

Myers, Stewart C., "Capital Structure," Journal of Economic Perspectives Vol. XV(2), 2001, 81-102.

Stern, Joel M., G. Bennett Stewart III and Donald H. Chew, Jr., "EVA[R]: An Integrated Financial Management System," European Financial Management Vol. II(2), 1996, 223-245.

U.S. Department of Commerce, Bureau of Economic Analysis, Table 1.1.5 (Gross Domestic Product), August 2007, www.bea.gov.

Dr. Carlos A. Colon-De-Armas earned his Ph.D. at the Krannert Graduate School of Management, Purdue University in 1984. Currently he is a professor of finance at the Graduate School of Business of the University of Puerto Rico, San Juan, and an Adjunct Professor of Finance at the University of Phoenix, Puerto Rico Campus.
MARKET VALUE BALANCE SHEET

ASSETS                       DEBT & EQUITY

Current assets      $ xx     Debt                $ xx
Fixed assets          xx     Common equity         xx
Other assets          xx

            V        $XX               D&E        $XX
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