WACC Deep Dive

Question 1

Conceptually what is cost of equity?

Answer 1

Returns from stock price increases and dividends

Question 2

Conceptually what is cost of debt?

Answer 2

Returns from interest and mv of debt changing

Question 3

What is WACC formula?

Answer 3

CoE * %E + CoD * (1-T) * %D + Cost of preferred stock * %Prefered stock

Question 4

Why do we add prefered stock seperately?

Answer 4

BC it is not tax deductible and more expensive but similar to debt

Question 5

How to determine %E for WACC?

Answer 5

Public:
- Look at EQV and debt and calc %
- Mcap as weight

Private:
- Compare to other companies through multiples
- backsolve the dcf
- assume generic ratio

Question 6

How to determine cost of debt?

Answer 6

Public:
- YTM on its long term bonds: YTM*(1-T)
- Risk free rate+Average yield spread (if it has credit rating)
- interest exp/ debt or average debt (quick approximation)
- Credit swaps

Private:
- Look at bonds of comparable companies
- Look at credit spreads of comparable companies
- Use weighted average interest of the loans
- Compute Interest cov ratio and use it as synthetic rating. Use corresponding market yield for that rating and then use tax shield

Question 7

How to determine cost of equity

Answer 7

Public:
- Capm
- Farma French (factor size and value)
- Dividend Discount Model ( Coe = (Div next year/current share price) + long term growth
- Projected NI/ MCap

Private:
- Capm
- Implied IRR (for PE owned)

Question 8

What risk free rate to choose if country is not AAA?

Answer 8

• Value in stable currency ( use risk free rate of that currency and add country risk premium)
• Value in local currency and use sovereign bond yield - default spread

Question 9

What happens to CF if WACC increases or decreases?

Answer 9

If wacc increases, cf fall, so TEV falls

If wacc decreases, cf increases, so TEV increases

Question 10

How would you rank the strongest drivers in a dcf?

Answer 10

1. Cash flows
   10% increase roughly translates into a 10% in EV
2. WACC
   Non linear effect but exponential, can move changes up to 10-30%
3. Growth rate

Question 11

How to select Beta?

Answer 11

• Comparables approach
  1. Get from BB or Factset levered betas
  2. unlever each beta
  3. compute median
  4. Relever the beta
• Using sector averages (Damodaran Online)

Question 12

What is raw and adjusted beta?

Answer 12

Raw beta is deirectly calc from regression

Historical Beta is the same but based on past data (2- 4 Years)

Adjusted beta is: 2/3 * raw beta + 1/3 * 1

Question 13

Why do we adjust beta?

Answer 13

• Mean reversion, companies beta tend to move to 1 over time
• adjustment anticipates this pull

Question 14

What are current betas?

Question 15

What are the limitations of WACC

Answer 15

• Difficult in practice
• Difficult to apply to specific projects or SOTP
• Use of historical data/ Valuation is forward looking

Question 16

Are leases part of WACC?

Answer 16

Yes finance leases but often times too small to really affect them

Ignore operating leases in WACC

Question 17

Does higher tax rate increase or decreseve TEV

Answer 17

Usually decreases TEV, bc despite WACC decreasing CF also decreases

Question 18

What is the difference between effective and marginal tax rate?

And which to use for dcf?

Answer 18

Effective: represent the % of taxable income corporate must paz in taxes
Historical: Taxes Paid/ Earnings before Taxes

Marginal: taxation % on the last dollar of a companys taxable income
depends on statutory tax and jurisdiction as tax bracket is adjsuted

Question 19

For forecasting purposes, do you use the effective or marginal tax rate?

Answer 19

• effective tax rate will be lower than the marginal tax rate, mainly because many
  companies will defer paying the government.

Recommend: look at historicals and base tax rate assumptions on effectuve tax rate, but for TV normalize it to be close to marginal tax rate

Question 20

How does a lower tax rate impact the valuation from a DCF?

Answer 20

1. Greater Cash flow
2. Higher cost of debt
3. Higher Beta: