If YESThen understanding WACC is vitallyimportantA’Ohlin Commercial Insights © 2013 Page 1Do YOU want CHEAPER water & sewe...
Weighted Average Cost of Capital(WACC)– Post GFCa Revision Lower is NeededA’Ohlin Commercial Insightswww.aohlininsights.co...
• Broadly speaking, a company’s assets are financed by either debt or equity.• WACC is the average of the costs of these s...
Firm is interested in investing in a new shopping centre or commercialdevelopment it should go ahead if the returns forec...
• Cost of equity– no longer is an equity risk premium acceptable– the risk free rate proxy, the 10 year government bond ra...
Cost of Debt (Rd)• Interest rates have plummeted• Cost of raising debt is at an all time lowCost of Equity (Re)• Risk Free...
Reserve Bank of AustraliaStatement by Glenn Stevens, 6 November 2012• Global growth is forecast to be a little below avera...
A’Ohlin Commercial Insights © 2013 Page 8The premium differential between debt and equity is reducinga lower cash rate is ...
A’Ohlin Commercial Insights © 2013 Page 9The equity (stock market) premium over the “risk free” Australian 10-year governm...
A’Ohlin Commercial Insights © 2013 Page 10A case is being made for the Australian equity market riskpremium (MRP) to be re...
Reserve Bank of AustraliaStatement by Glenn Stevens, 6 November 2012 (continued)• “Savers are facing increased incentives ...
Australian Banks and Financial InstitutionsThe big four banks reported a combined annual profit of more than $25 billionfo...
Australian Banks and Financial Institutions (continued)How have they got there?• Slashing more than 6,600 jobs over the pa...
Australian Banks and Financial Institutions (continued)What’s behind the cry of “higher funding cots”?• Funding costs have...
Australian Banks and Financial Institutions (continued)Issues driving higher funding costs:• Mr Jason Yetton, head of reta...
Australian Banks and Financial Institutions (continued)Issues driving higher funding costs (continued):A’Ohlin Commercial ...
Australian Banks and Financial Institutions (continued)Issues driving higher funding costs (continued):• The banks are doi...
Australian Banks and Financial Institutions (continued)Issues supporting lower funding costs:• Global bond rates are at re...
Australian Banks and Financial Institutions (continued)Issues supporting lower funding costs (continued):A’Ohlin Commercia...
Australian Banks and Financial Institutions (continued)Issues supporting lower funding costs (continued):• CBA raised $US2...
What does this mean?• Overall, wholesale funding costs have come down, however:a. the actual cost to each bank will depend...
What does this mean to the WACC?WACC = weighted cost of debt + weighted cost of equity• Applying the change in AFMA Intere...
What does this mean to the WACC’s cost of equity (Re)?Re = cost of equityRF = risk free rate (the 10 year government bond ...
WACC = weighted cost of debt + weighted cost of equity• Lower cost of Debt (Rd)• Lower Cost of Equity (Re)A case is made f...
If YESThen understanding WACC is vitallyimportantA’Ohlin Commercial Insights © 2013 Page 25Do YOU want CHEAPER water & sew...
To refresh your understanding of WACC fundamentals visit“WACC 101 – an introduction” athttp://www.slideshare.net/AOhlinIns...
Weighted Average Cost of Capital(WACC)– Post GFCa Revision Lower is NeededA’Ohlin Commercial Insightswww.aohlininsights.co...
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Cheaper prices: WACC- post GFC a revision lower is needed

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this document explains how the Weighted Average Cost of Capital (WACC) is calculated and how it impacts pricing. Pressure must be placed on government utilities to reduce the WACC's used in ther determination of required revenues and consumer pricing

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Cheaper prices: WACC- post GFC a revision lower is needed

  1. 1. If YESThen understanding WACC is vitallyimportantA’Ohlin Commercial Insights © 2013 Page 1Do YOU want CHEAPER water & sewerage and electricity prices?
  2. 2. Weighted Average Cost of Capital(WACC)– Post GFCa Revision Lower is NeededA’Ohlin Commercial Insightswww.aohlininsights.com3 December 2012A’Ohlin Commercial Insights © 2013
  3. 3. • Broadly speaking, a company’s assets are financed by either debt or equity.• WACC is the average of the costs of these sources of financing, each of whichis weighted by its respective use in the given situation.• By taking a weighted average, we can see how much interest the companyhas to pay for every dollar it finances.• A firms (or a project’s or a business unit’s) WACC is the overall requiredreturn on the firm as a whole and, as such, it is often used internally bycompany directors to determine the economic feasibility of expansionaryopportunities and mergers.• It is the appropriate discount rate to use for cash flows with risk that is similarto that of the overall firm.Weighted Average Cost of Capital is the percentage cost (interest) orreturn required to finance a company or project by debt and/or equityA’Ohlin Commercial Insights © 2013 Page 3
  4. 4. Firm is interested in investing in a new shopping centre or commercialdevelopment it should go ahead if the returns forecasted to be generated are at least equalto the WACC if they are below the WACC, then the project is not expected to generateenough return to compensate those providing the debt (usually the banks)nor is it sufficient to compensate the owners (equity) for also risking theirmoneyWACC is used as a hurdle rate when making investment decisionsA’Ohlin Commercial Insights © 2013 Page 4
  5. 5. • Cost of equity– no longer is an equity risk premium acceptable– the risk free rate proxy, the 10 year government bond rate, has been atconsistently low levels with the RBA implying that this will continue• Cost of debt– wholesale funds are at record low levels– banks are shifting their cost structure from wholesale funding market exposure tothe relatively more expensive self-funded deposit marketA’Ohlin Commercial Insights © 2013 Page 5Cost of funding has undergone structural change and must be re-assessed downwards
  6. 6. Cost of Debt (Rd)• Interest rates have plummeted• Cost of raising debt is at an all time lowCost of Equity (Re)• Risk Free Rate (Rf)– 10 year government bond rates at an all time low– Australia is one of a handful of countries retaining AAA credit status• We can borrow money in international markets at cheaper rates because we areconsidered to be “less risky” or “more credit worthy”• Premium for investing in a “riskier asset”– 6% Market Risk Premium has been Australia’s historical average to 2010– since December 2010, the global market has materially changed with Australianow being regarded as relatively safe, and thus driving down our Market RiskPremiumA’Ohlin Commercial Insights © 2013 Page 6Historical WACCs, particularly those used by the public sector, areno longer applicable in today’s environment
  7. 7. Reserve Bank of AustraliaStatement by Glenn Stevens, 6 November 2012• Global growth is forecast to be a little below average for a time• Risks to the outlook are still seen to be to the downside (largely due to situation inEurope)• Long term interest rates faced by highly rated sovereigns, includingAustralia, remain at exceptionally low levels• Capital markets remain open to corporations and well rated banks• Australian banks have no difficulty accessing funding, including on an unsecuredbasis• Borrowing conditions for large corporations are similarly attractive• Expected benefits of lower cash rates are starting to have an effect, namely:– Stronger housing market– Higher stock pricesA’Ohlin Commercial Insights © 2013 Page 7The Reserve Bank of Australia advises that long term interest ratesremain at exceptionally low levels
  8. 8. A’Ohlin Commercial Insights © 2013 Page 8The premium differential between debt and equity is reducinga lower cash rate is reducing the premium differential betweenasset classes, with the intention of attracting investors into theproperty and stock markets – a covert attempt to stimulate theeconomy. This in turn means the premium differentialbetween debt and equity is reducing, reflecting a structuralshift in the cost of funds to a lower base.No longer is an equity risk premium of 5 to 6 per cent acceptable.i.e. the belief that shares offer annual excess returns of 5 to 6 percent over government bonds is now being questioned, and mayhave significant implications on the pricing determinations ofseveral government agencies (such as the Australian EnergyRegulator when determining acceptable gas and electricitymargins, and the Regulators of water utilities in setting water andsewerage pricing margins).
  9. 9. A’Ohlin Commercial Insights © 2013 Page 9The equity (stock market) premium over the “risk free” Australian 10-year government bonds over the past 30 years is actually very small.Between 1982 and 2012:Australian shares provided a compound annual (geometric) return of12.3% (with annual volatility or risk of 17.7%)Australian government bonds generated a compound annual return of11.7% (with a volatility or risk of 8.6%)This suggests an equity risk premium of only 0.6%.Imputation credits may bump this up another percentage point.However, 1.6% is still well below the previously accepted norm of 5 to 6per cent.(C Joye, The AFR, 3 Oct 2012)
  10. 10. A’Ohlin Commercial Insights © 2013 Page 10A case is being made for the Australian equity market riskpremium (MRP) to be reduced by 2% down to 4%The equity MRP is generally measured as the difference between a sharemarket holding period return and a Government bond yield to maturity.While capital gains are implicitly captured in the share market return, forsome reason these are generally ignored in estimating the return on arisk free asset.This, together with a recalculation of government yields - whichincorporates the effects of capital gains/losses and the effects ofuncertain coupon rates –…results in an equity MRP of 4%, rather than 6%.(C Joye& Professor Richard HeaneyWinthrop Professor Accounting and Finance, UWA Business School) 11. Heaney,R. & Kidd,S. A note: Calculating the Market Risk Premium: Does the risk free rate calculation matter?, draft copy, awaiting publicationC Joye, The AFR, 3 Oct 2012
  11. 11. Reserve Bank of AustraliaStatement by Glenn Stevens, 6 November 2012 (continued)• “Savers are facing increased incentives to look for assets with higher returns”(Glenn Stevens)• Recent outcomes on inflation were slightly higher than expected• Needed to keep inflation low– Contain pressure on labour costs in sectors other than those directly affected bycurrent strength in resources sector– Improvement in productivity performanceA’Ohlin Commercial Insights © 2013 Page 11The Reserve Bank of Australia is indicating that rates will remainlowGovernor Stevens is suggesting investors (such as self-funded retirees) should actively seekalternatives to parking their money in relatively low yielding savings account (which in turnputs added pressure on banks to lift deposit rates and thereby squeeze margins – seecomments below).This is a “heads up” / indication that rates will remain low, if not lower, in coming months.
  12. 12. Australian Banks and Financial InstitutionsThe big four banks reported a combined annual profit of more than $25 billionfor the 2012 financial year [$25.2 billion in 2012 up from $24.2 billion in 2011]• Record billion dollar profits despite the GFC and contracting global economies– 6 Nov 2012 CBA makes $1.8bn in 3 months: CBAs unaudited cash earnings wereapproximately $1.85 billion in the three months to September, up six per centfrom approximately $1.75 billion in the same period the previous year– 5 Nov 2012 CBA was the standout with a bumper $7.1 billion profit while rivalNational Australia Banks $5.4 billion profit– 24 Oct 2012 ANZ reports a top line 6 per cent increase in full-year cash profit to arecord $6.01 billion and a dividend hikeA’Ohlin Commercial Insights © 2013 Page 12The Big Four Banks are making record BILLION dollar profits…
  13. 13. Australian Banks and Financial Institutions (continued)How have they got there?• Slashing more than 6,600 jobs over the past year (The AFR, Wed 7 Nov 2012)• Accessing cheaper funds– However, the banks continually bemoan “weaker interest margins because ofhigher funding costs” (The AFR, Wed 7 Nov 2012) - this is false!A’Ohlin Commercial Insights © 2013 Page 13…by slashing jobs and accessing CHEAPER funding
  14. 14. Australian Banks and Financial Institutions (continued)What’s behind the cry of “higher funding cots”?• Funding costs have 2 components: cost of debt + cost of equity– Cost of debt = interbank swap rate + lending/default risk premium– Cost of equity = risk free rate (typically the 10 year bond rate) + market riskpremium (typically taken as the average yield on traded stocks), adjusted by a riskfactor specific for that business or project• Debt is typically cheaper than Equity (and has a tax shield effect, preservingprofits)A’Ohlin Commercial Insights © 2013 Page 14But the banks are crying poor
  15. 15. Australian Banks and Financial Institutions (continued)Issues driving higher funding costs:• Mr Jason Yetton, head of retail and business banking at Westpac (the AFRWed 7 Nov 2012), said funding costs are increasing for a number of reasonswith the primary one being that the price of deposits is high• Due to market volatility, banks are seeking more and more to self-fund loanasset portfolios through deposits (relatively more expensive than wholesaledebt funding)– Increased competition for deposit funding is driving up deposit rates for banks– This together with lower cash rates=> driving up banks’ cost of deposits=> drives up cost of bank loans to customers=> increases cost of debt for those businesses/people wanting toborrow money from the banksA’Ohlin Commercial Insights © 2013 Page 15Increased competition for deposit funding is driving up depositrates for banks which also drives up the cost of bank loans
  16. 16. Australian Banks and Financial Institutions (continued)Issues driving higher funding costs (continued):A’Ohlin Commercial Insights © 2013 Page 16The RBA’s “Bank funding” chart shows the increasing proportion ofdomestic deposits since 2008 and the reduction in debtnote:Deposits are also a form ofdebt funding. As previouslynoted, deposit funding isgenerally relatively moreexpensive than wholesaledebt funding.
  17. 17. Australian Banks and Financial Institutions (continued)Issues driving higher funding costs (continued):• The banks are doing whatever they can to maximise shareholder profits, and• The problem in Australia is that they are doing this in a non-competitiveenvironmentA’Ohlin Commercial Insights © 2013 Page 17Australian banks are doing whatever they can to maximise profitsin a non-competitive environment
  18. 18. Australian Banks and Financial Institutions (continued)Issues supporting lower funding costs:• Global bond rates are at record low levels => lower cost of equity• Australia is one a only a few remaining AAA sovereign risk countries which meansit can borrow money relatively cheaply => lower cost of debt and equity• Source of bank funds borrowed on international wholesale markets has fallen =>lower of cost debt (Mr Jason Yetton head of retail and business banking, Westpac)• Long term interest rates faced by highly rated sovereigns, including Australia,remain at exceptionally low levels (RBA November 2012)• Australian banks have no difficulty accessing funding, including on an unsecuredbasis (RBA November 2012)• Borrowing conditions for large corporations are similarly attractive (RBANovember 2012)A’Ohlin Commercial Insights © 2013 Page 18Borrowing conditions for Australian banks are very attractive withrecord lows in cost of debt and equity
  19. 19. Australian Banks and Financial Institutions (continued)Issues supporting lower funding costs (continued):A’Ohlin Commercial Insights © 2013 Page 19Bank spreads have FALLEN since January 2012…source: The Australian Financial Review, Friday 11 January 2013
  20. 20. Australian Banks and Financial Institutions (continued)Issues supporting lower funding costs (continued):• CBA raised $US2 billion of three-year money through on Wednesday night (9January 2013) at a cost substantially less than it paid a year ago;• CBA will pay investors 44 basis points above the benchmark treasury rate• In March last year (2012) CBA paid 140 basis points above the benchmarktreasury rate to issue five-year covered bonds to US investors.• That’s a savings of nearly 100 basis points; a fall of 68.57%– Yes, it is true that five-year bonds should be more expensive than three-yearbonds, however the size of the difference (nearly 100 basis points) highlights howfar wholesale funding costs have fallen on international markets in the past 12months.A’Ohlin Commercial Insights © 2013 Page 20… and banks are able to raise substantially cheaper debt
  21. 21. What does this mean?• Overall, wholesale funding costs have come down, however:a. the actual cost to each bank will depend on its individual funding mixb. historically held debt, such as five-year money (i.e. entered into 5 year’s ago)may still be cheaper than money sourced today, despite the recent fall inspreads; if the money was sourced one year ago, today’s money will mostprobably be cheaper• Cost of funding has undergone structural change and must be re-assessed– Cost of equity• no longer is an equity risk premium acceptable• the risk free rate proxy of the 10 year government bond rate has been at consistentlylow levels with the RBA implying that this will continue– Cost of debt• wholesale funds are at record low levels• banks are shifting their cost base from exposure to the wholesale funding market tothe relatively more expensive self-funded deposit marketA’Ohlin Commercial Insights © 2013 Page 21Cost of funding has undergone structural change and must be re-assessed
  22. 22. What does this mean to the WACC?WACC = weighted cost of debt + weighted cost of equity• Applying the change in AFMA Interest Rate Swaps from data/report publication dates to thecurrent date, will give an indication of the current cost of debt (i.e. as at 3 December 2012)EXAMPLE:• Tasmania’s Economic Regulator published a cost of debt for water pricing in March 2012 of7.02%.• In March 2012 the 3 year Interest Rate Swap was 4.280• By December 2012 the 3 year Interest Rate Swap was 3.085• CHANGE of -27.92%• An argument could then be presented that the cost of debt appropriate for the TasmanianWater Utilities should be revised down by 27.92% to 5.06%.• Further supporting this - as presented earlier - the wholesale cost of bank funding inAustralia has fallen.A case is made a LOWER cost of debt.A’Ohlin Commercial Insights © 2013 Page 22A case is made to LOWER the cost of debt (Rd)
  23. 23. What does this mean to the WACC’s cost of equity (Re)?Re = cost of equityRF = risk free rate (the 10 year government bond rate is often used as a proxy)Be = beta of equity ie. a measure indicating how risky that particular organisation isrelative to the Australian market place (stock market), a Beta of 1 would mean theorganisation is considered to have a risk profile the same as the Australian sharemarket(RM – RF) = equity Market Risk Premium i.e. the premium investors demand for taking onperceived additional risk by trading in the Australian equity markets (stockmarket), rather than investing in the relatively “risk free” option of governmentbonds• As presented earlier– a case can be made for a Market Risk Premium of 4% (as opposed to the traditionally used 6%)– the risk free rate – 10 year government bond rate – has now also fallenA case is made a LOWER cost of equity.A’Ohlin Commercial Insights © 2013 Page 23A case is made to LOWER the cost of equity (Re)
  24. 24. WACC = weighted cost of debt + weighted cost of equity• Lower cost of Debt (Rd)• Lower Cost of Equity (Re)A case is made for a LOWER Weighted Average Cost of Capital (WACC)• LOWER investment hurdles• LOWER revenue streams are required from investments to cover the fundingcosts (both debt and equity)And this means,LOWER PRICES FOR CONSUMERS(particularly in government utilities such as electricity and water & sewerage)A’Ohlin Commercial Insights © 2013 Page 24A case is made to LOWER the WACC and supports the case toreduce prices to consumers of government utilities: cheaper prices
  25. 25. If YESThen understanding WACC is vitallyimportantA’Ohlin Commercial Insights © 2013 Page 25Do YOU want CHEAPER water & sewerage and electricity prices?
  26. 26. To refresh your understanding of WACC fundamentals visit“WACC 101 – an introduction” athttp://www.slideshare.net/AOhlinInsights/weights-average-cost-of-capital-wacc-101A’Ohlin Commercial Insightswww.aohlininsights.comA’Ohlin Commercial Insights © 2013
  27. 27. Weighted Average Cost of Capital(WACC)– Post GFCa Revision Lower is NeededA’Ohlin Commercial Insightswww.aohlininsights.com3 December 2012A’Ohlin Commercial Insights © 2013

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