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# Chapter4 modelling innovation - teaser

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Chapter 4 focuses on describing how to estimate and calculate Weighted Average Cost of Capital, answering the following questions: …

Chapter 4 focuses on describing how to estimate and calculate Weighted Average Cost of Capital, answering the following questions:

How is the WACC calculated?
What is the Cost of Debt, Cost of Equity and Beta?
What is the periodicity of WACC calculation?

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• 1. Modelling Innovation – CHAPTER 4 Chapter 4 The weighted average cost of capital1 4.1 What is the WACC? The WACC is the appropriate discount rate of a company’s cash flows given its capital structure. The capital structure of a company includes Equity,Debt, as well as other forms of financing (including hybrid securities). The WACC is the average cost of these types of capital, according to the proportion thateach represents in the company’s capital structure. The WACC takes into account the return for equity and debt holders and is the right discount rate to calculatethe Enterprise Value and, based on that figure, the company’s Equity Value (and as a result, other measures including share price estimates). The shareholders’ return on their shares (the return on equity) represents a financial cost to the company and is usually higher than the return demandedby banks and investors in order to extend finance to the company in the form of loans, bonds or other fixed income securities. Equity holders will only obtainreturns on their investment after paying off other security holders, due to the nature of the equity contract. Accordingly, equity investors demand a higher returnthan debt holders or bondholders. The DCF method takes this into account in the WACC, which is a blended cost of capital. 4.2 The WACC equation The DCF methodology is extremely sensitive to the discount rate and therefore the WACC should be calculated in detail. An interpretation andcomparison to reality should be made before using the WACC in the DCF model. The following formula uses the case of a company financed by Equity, Debt 1 © 2012, Hugo Mendes Domingos and Eduardo Vera-Cruz Pinto 1
• 2. and Preferred Shares. A variation of the same formula would be used if the analysed company used other forms of capital, such as convertibles or other hybridsecurities. Equation 1. Weighted Average Cost of Capital Formula In this formula, the WACC is calculated after tax in the sense that the cost of debt taken into account allows for the tax shield impact of debt financing.Interest is usually tax deductible, and as a result, a company’s cost of debt should be considered net of the tax savings generated by the fact that the company willreduce its tax payments to the extent that it uses debt as a form of financing. Preferred Shares are presented in the calculation of the WACC without taxation as itis a hybrid form of finance (with both debt and equity characteristics) and its coupon may be classified as a dividend and is usually not tax deductible (except insome countries). For the sake of simplicity, we assume that the interest paid on preferred shares is non tax-deductible. 4.3 What is the Cost of Debt? The cost of debt in valuation models is the annual cost that the company incurs for being financed by debt (assuming that the model itself is annual).This cost is normally mistaken for the interest rate on bank loans; however there are other debt instruments that dismiss this simplistic view, including bonds,
• 3. Modelling Innovation – CHAPTER 4bank loans and other forms of fixed income financing. What is needed is a general formula that takes into account the fact that the same company could befinanced using various forms of debt or via the fixed income capital markets. The formula for determining the cost of debt is as follows: Equation 2. Cost of Debt 𝐾 𝐷 = 𝑅𝑓 + 𝑆𝑝𝑟𝑒𝑎𝑑 + 𝐶𝑅𝑃𝐾 𝐷 → 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡𝑅𝑓 → 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒𝐶𝑅𝑃 → 𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚  The Risk Free Rate for the Cost of Debt and the Country Risk Premium This parameter is the minimum cost of debt (if the spread is zero) and is theoretically a zero-coupon bond. Since zero-coupon bonds are not immediatelyavailable at all maturities, an acceptable estimation is to use the yield on a Government bond. At first, the analyst might have the tendency to bonds of the countrywhere the company is headquartered. In practice, this is not the best approach. For European countries, we recommend the use of a German bund, especially ifthe company consolidates in euros. The specific risk associated with the country is captured by the country risk premium (CRP), which is described later on. Inthe case of a UK company reporting in Pounds Sterling, the UK Government bond yield should be used. In that case, there is no need to use the CRP since theGovernment bond used as a proxy for the Risk Free Rate captures the country’s risk. The same principle would apply to a German company. For companies thatoperate in various countries, a separate analysis should be conducted for every country that is a material contributor to the revenues. In those cases, a specificWACC (and a specific cost of debt) should be calculated for each country. The analyst should use bonds with maturity equal to the projection period of valuation.When in doubt, the standard favoured by practitioners is the 10-year bond.  The Spread This spread is the additional return from the risk-free rate, demanded by banks, creditors or fixed income investors, when extending finance to aparticular company. If the company has issued bonds listed on an exchange, the spread will be calculated based on the yield to maturity of those bonds. If thecompany has obtained a credit rating, its spread is usually public information or can be obtained from the agency that issued the rating. 3