My Take on WACC

Much of my writing has a theme: avoiding the weighted average cost of capital (WACC).

In my opinion, WACC makes sense, but it is hard to use!

Capital, like labor and raw materials, comes from different sources, in different amounts, with different costs.  If we know those amounts and costs, we can calculate their weighted average.

The problem with WACC is that there are many complications involved in determining those sources, amounts, and costs.  They range from theoretical issues to definitions, assumptions, and practical problems.

Rather than present a broadside of complications, let me jump into a prototypical valuation engagement. We are deciding whether to use WACC.  We have defined the engagement parameters, done economic, industry, and company analysis, and completed a financial workup including a multi-year forecast (income statements, balance sheets, and cash flow statements).

Astute readers will note that if we have come this far, we have forecasted net cash flow to equity and can use that forecast (with a discount or capitalization rate) to complete the Income Approach.  Right on: and WACC need not be used!

To get here, we had to address many issues (not all arise in every valuation):

1. We determined the amount of debt of each type (e.g. bank loans, leases, shareholder loans, etc.) and its direct costs (interest expense and principal repayment) outstanding at the end of each forecast year. We had to do this in order to project net cash flow to equity.
2. The amount of total debt (from all sources) and the book value of equity were determined for each year.  The ratio of total debt to book equity (one measure of the debt / equity ratio) was also determined (implicitly) for each year, and it might vary.
3. If there were any constraints on borrowing (e.g. only asset-based loans were available, loan covenant compliance had to be considered, or banks were not willing to lend due to tight credit markets), we took those into account.
4. If interest rates or the cost of equity were projected to vary over time, our projection reflected that. (Variable cost of equity would show up in our discounted cash flow analysis.)
5. Lease costs (including purchase options at the end of the lease periods) were figured into our projection.
6. The cost of preferred stock, including dividends, liquidation preferences, and redemptions, were also figured into our projection.
7. Issues related to classification of debt (is it short- or long-term?) were avoided: as long as it appears on the balance sheet and its interest and principal repayment was properly specified, this makes no difference save for computation of some financial ratios (such as the current ratio).
8. We did not have to address the market value of debt (or equity).  Debt is stated at borrowed amounts; equity is stated at book value.
9. We did not have to address “industry normal” debt ratios, which might or might not be appropriate for our subject given case facts and circumstances as well as prevailing credit market conditions.
10. We did have to show that the business could adequately service all debt, paying interest each year and principal as scheduled, and meeting all relevant covenants and collateral requirements.
11. Only when there was positive net cash flow to equity (and proven compliance with relevant debt covenants) could dividends (or “S” distributions) be paid.  In other words, debt service had priority over dividends / distributions.
12. Our forecast of net cash flow to equity was (obviously) based on cash returns to the owners.
13. We also took into account (control) owners’ stated intentions: e.g. they might be very debt-averse and plan to repay debt as quickly as possible as permitted by cash flows, deferring potential dividends or distributions.
14. We also evaluated whether owners’ personal guarantees were sufficient (we had data on their personal finances to accomplish this, if it was relevant).
15. We were able to provide a detailed explanation of our basis for each assumption we made in the financial forecast, and similarly prove compliance with loan covenants, interest and principal payment schedules.
16. We probably had to fine-tune our projections; i.e. prepare several iterations until everything was okay.
17. All of this was a standard level of work as far as due diligence is concerned.

Astute readers will now note that each of these items can be a problem with WACC; each problem listed corresponds to the same point number as listed above:

1. WACC assumes a constant debt / equity ratio.
2. WACC assumes a constant debt / equity ratio.
3. WACC does not model borrowing constraints, loan covenant compliance, or bank credit limitations; it assumes a potentially infinite level of borrowing is possible.
4. WACC assumes constant debt and equity costs.
5. WACC does not handle lease costs.
6. WACC does not handle preferred liquidation preferences and redemptions.
7. WACC raises Issues related to classification of debt (is it short- or long-term?)
8. WACC forces us to determine the market value of debt and equity.  We assume a market value of equity and have to iterate until the assumed and concluded market values of equity are the same.
9. WACC raises the issue of “industry normal” debt ratios, which might or might not be appropriate for our subject given case facts and circumstances as well as prevailing credit market conditions.
10. WACC does not show that the business could adequately service all debt.
11. WACC does not give debt service priority over equity returns.
12. WACC requires calculation of cash flow to invested capital, as well as calculation of cash flow to equity.
13. WACC assumes constant debt / equity ratios.
14. WACC does not handle loan guarantees.
15. WACC requires a great deal of additional explanation.
16. WACC requires iterations (to make assumed and concluded market values of equity equal.)
17. WACC makes more work for us.

My bottom line on WACC is simply this: I believe that you can come up and defend with a reasonable assumption about projected debt in every valuation.  Having done so, you can calculate net cash flow to equity and capitalize or discount it.  You need not get into the extra work, difficulties, and explanations that WACC requires.