DISCOUNT RATES IN APPRAISAL WORK: THE WACC

DISCOUNT RATES IN APPRAISAL WORK: THE WACC

DISCOUNT RATES IN THE APPRAISAL ACTIVITY: THE WACC

As expressed in the previous article, https://bit.ly/3H7Q4yE, appraisal activity constitutes a professional sphere peculiar to the figure of the Certified Public Accountant and Auditor: after the CAPM, it is appropriate to elaborate here on the WACC, another predominantly used discounting rate and a fundamental component for proceeding in the correct estimation of valuations.

THE WACC

WACC, an acronym for "Weighted Average Cost of Capital", is the weighted average cost of capital of a security, investment project or company: it expresses the relative opportunity cost by evaluating the potential investment in terms of the average cost of financing sources. Consequently, it is used by professional estimators or analysts in general to express the correct evaluation of a strategy for buying and selling an asset or starting an industrial project.

Its calculation is given by the weighted average of the cost of equity capital, Ke, and the cost of debt capital, Kd:

𝑊𝐴𝐶𝐶 = 𝐾𝑒 ∗ 𝐸/(D+E) + 𝐾𝑑 ∗ 𝐷/(𝐷+𝐸) ∗ (1-𝑡),

the cost of equity capital, Ke, is considered according to the theory of the "Capital Asset Pricing Model," CAPM, as the rate of return on equity or the minimum rate of return that a firm must offer to its partners or shareholders in order to remunerate the funds received from them (see the previous article for its determination);
the cost of debt capital, Kd, on the other hand, can be calculated as
- Kd = interest expense/NFP, "net financial position," i.e., borrowings of a financial nature net of cash and cash equivalents, when the cost of debt can be traced through balance sheet data. In this case, the correct determination is highly dependent on when the debt is incurred, which is why the timing of the analysis is critical and the balance sheet data must be consistent with the valuation date;
- or otherwise through a market analysis, reconstructing the cost of debt as the sum of the risk-free yield on government bonds and the spread, calculated as a function of the yields to maturity on bonds of companies comparable in risk profile, i.e., Kd = rf + spread = i;
the value of the cost of debt capital is usually net of the tax shield, multiplying Kd ∗ (1-t), as the cost of debt is real, adjusted for tax savings on borrowing costs. The tax rate "t" is specific and measures the deductibility of interest expense: in Italy there are two taxes applied to business income, IRAP and IRES, calculated as follows. IRAP has EBIT as its taxable base and has a rate of 3.90%, IRES is paid by companies on taxable income, i.e. EBT, and the rate is 24%. However, before applying the latter rate, a 10% deductibility of IRAP paid is allowed, which must then be discounted in the calculation: this component is called the "Tax Asset" on interest expense;
the capital weighting percentages E/(E+D) and D/(D+E) express the composition of the corporate capital under consideration, as a function of equity E, i.e., equity capital, and debt D, i.e., debt capital, thus expressing immediate display of the percentage of each source of financing in relation to the total, varying from company to company depending on conformation.

FINANCIAL STRUCTURE DYNAMICS AND THE WACC

The change in the firm's financial structure is followed by the following important distinct effects on WACC, which can guide its relative strategic composition choices:

by issuing debt, the weight of equity decreases, WACC decreases, the effect of the tax shield makes debt even cheaper, further reducing WACC (D/E increases, Ke decreases and WACC decreases). This is why it is sometimes improperly customary to say that debt creates value;
/E ↑ → 𝑾𝑨𝑪𝑪 ↓
however, increasing debt leads to an increase in the cost of equity, Ke, as the relative βlevered increases; in fact, the D/E ratio increases, and when this ratio, also referred to as the leverage ratio, becomes too high, the cost of debt Kd also increases: this occurs because lenders faced with greater risk will demand greater return, having the fear that the firm may have financial difficulties in meeting its large contractual commitments or may even go into financial distress and fail (D/E increases, Ke increases, Kd increases, WACC increases).
/E ↑ → 𝑲𝒆 ↑ 𝑲𝒅 ↑ → 𝑾𝑨𝑪𝑪 ↑

Let us now analyze a firm that has no debt initially, 𝐾𝑒 = 𝑊𝐴𝐶𝐶: if debt is included, two distinct moments can be distinguished, which create important consequences for the firm's financial structure (see the actual firm graphs shown):

the initial moment when the issuance or assumption of debt takes place, where 𝐾𝑑 remains at low levels (in the present case always less than 4 percent), since the level of leverage at the beginning is very low, less than 50 percent. In this case, the weight effect of the D/E ratio and the tax benefit outweighs the increase in the cost of the two sources of financing, so the WACC decreases, as can be seen in the second graph, generating a benefit to the financial structure;
however, when debt grows beyond a certain threshold, usually over 50 percent, it creates a significant increase in the cost of debt, 𝑲𝒅grows due to excessive leverage and thus risk to lenders, in turn causing 𝑲𝒆 to increase exponentially: the above causes the increase in the cost of the two sources of financing to prevail over the effect of the D/E ratio and the tax shield, leading to a significant growth in WACCand a burden to the corporate financial structure.

CONCLUSIONS

Consequently, considering these simple exemplifications, it becomes clear to understand how important it is to balance the corporate financial structure: in general, the optimal level of the financial structure is the one that minimizes WACC, i.e., that target D/E level that allows to take full advantage of the benefits from the decrease in the weight of equity and the related tax shield, net of the disadvantages from the increase in the cost of the two sources of financing and potential financial distress situation for investors: this level is company specific, i.e., dependent on the company and the target market.

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