Discount Rates and WAAC
If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt, how does that affect its WACC?
Depends on how you are calculating WACC: -if current..... WACC will probably increase because 20% is a low Debt level -if targeted.... no affect on capital structure
What are the formulas for unlevering and relvering Beta, and what do they mean?
Only equity and debt... -Unlev = lev beta / (1 + debt/eq ratio*(1-tax rate)) -Lev = unlev beta * (1 + debt/eq ratio*(1-tax rate)) if there is PS add another term for P/Eq ratio tax deductibility reduces risk of debt. formulas reduce lev beta to represent removal of risk from leverage, but inc unlev beta to represent addition of risk from lev
How does the Cost of Preferred Stock compare with the Costs of Debt and Equity?
PS tends to be more expensive (offers higher risk and potential rewards) than debt, but less expensive (offers lower risk and potential returns) than Equity.
Should you use Total Debt or Net Debt to determine the capital structure percentages in the WACC calculation>
Should use Eq Value + Debt + PS - cash does not "offset" Debt ... -you may get nonsensical results with high cash balances
What does WACC mean intuitively?
Similar to Cost of equity - expected annual return % if you invest proportionately in ALL part of companys capital structure (Debt, Eq, PS..) To company, represents cost of funding its operations by using ALL of its sources of capital
What are some different ways to calculate Beta in the Cost of Equity calculation?
Some people argue you should use Predicted Beta instead of Historical Beta - because Cost of Equity relates to expected future returns. -if you do use historical data - could use company's OWN or the relevered Beta based on historical performance of comparable companies
What should you use for risk free rate if gov bonds in that country are not risk free (greece)?
Take risk free rate in a country that is assumed to be risk free and add a default spread based on your countrys credit rating
Why do you have to unlever and relever beta when calculating cost of equity?
-Could use company's historical beta and skip this step... Valuation - estimating a company's implied value (what it should be worth) -unlevering beta for each comparable company - isolate company's inherent business risk (isolate risk and remove risk from leverage) -take the median of this and relever based on targeted capital structure of company you are valuing (there is always risk from leverage!)
Why is Equity more expensive than Debt?
Because it offers higher risk and higher potential returns. Expected stock market returns exceed interest rates on Debt in most cases, which makes Cost of Eq higher Interest on Debt is also tax deductible which reduces its cost
How do you calculate cost of equity?
COE = risk free rate + equity risk premium(levered beta) -risk free rate = what you would earn on risk free gov bonds of same currency as companys cash flows -levered beta = how volatile the stock is relative to the market - factoring in intrinsic risk and risk from leverage -equity risk premium = how much the stock market in companys country will return above the risk free bond stocks are risker and have higher potential returns than gov bonds. take rate of return of gov bond, add extra returns could get from stock market and adjust for companys specific risk/return
How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?
Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy -- affects all investors Exact impact on WACC depends where you are on the curve of Debt -if company is already at a high level of Debt - WACC is likely to increase with more Debt -at lower levels of Debt, WACC is more likely to decrease with more Debt
How do all those figures change as the company uses less Debt?
Cost of Equity and Cost of Debt decrease.... WACC could go either way depending on where you are on the curve -high levels of debt - less will decrease WACC -low levels of debt - les will increase WACC
How do convertible bonds factor into the WACC calculation?
If the company's current share price exceeds the conversion price of the bond, count the bonds as Equity and factor them in by using a higher diluted share count.... If not, the bonds are not convertible and you count them as Debt and use the coupon rate to calculate their Cost for CURRENT capital structure. if using optimal or targeted - company's convertible bonds won't factor in
Should you use the companys current capital structure or optimal capital structure to calculate WACC?
In practice you will use the median capital structure %'s from comparable public companies as a proxy for the "optimal" capital structure... better to use this expected capital structure bc company's implied value in a DCF is based on its expected, future cash flows
What does the cost of equity mean intuitively?
It tells you the percentage a company's stock should return each year. In valuation - % an equity investor might earn each year. To a company - represent cost of funding its operation by issuing shares to new investors.
What does Beta mean intuitively?
Levered beta tells you how volatile a company's stock price is relative to the stock market as a whole - factoring in both intrinsic business risk and risk from leverage (debt) -if beta is 1 when the market goes up by 10% , stock price goes up by 10% -if 2 - company goes up 20% Unlevered Beta: excludes risk from leverage, less than lev beta
How do you calculate the equity risk premium for a multinational company that operates in many different geographies?
May take % revenue from each country, multiply it by ERP in that market and add everything up to get a weighted average ERP- anything described above (historical US stock market return + default spread)
How do you determine the Cost of Debt and Cost of PS in the WACC calculation and what do they mean?
These costs represent the marginal rates a company would pay if it issued additional Debt or PS. -weighted avg coupon rate on company's existing Debt or PS -calculate median coupon rate on outstanding issuances of comparable companies -yield to maturity -take risk free rate in country and add a default spread based on company's expected credit rating
WACC reflects the company's capital structure, so why do you pair it with Unlevered FCF? It's not capital structure-neutral!
Think of Unlevered FCF as free cash flow to firm... -think of the relationship as FCFF as being available to all investors and WACC represents all investors.
If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?
Use the rate on gov bonds that match currency of companys cash flows
How do you calculate WACC, and what makes it tricky?
WACC = cost of equity * % equity + cost of debt * (1-tax rate) * % debt) + cost PS * % PS trick because ambiguity with items -cost of debt : do you use weighted average coupon rate on company's bond? Yield to maturity? -% of debt, eq, PS: do you use company's current capital structure, optimal, or targeted -COE : different ways to calculate Beta, not a lot of agreement on equity risk premium
Could Beta ever be negative?
Yes it is possible - company's stock market moves in the opposite direction of the market as a whole (ex: Gold)
In those formulas, you're not factoring in the interest rate on Debt. Isn't that wrong? More expensive Debt should be riskier.
Yes tis is the one drawback of this approach. However: -debt/equity ratio is a proxy for interest rates on Debt -risk isn't directly proportional to interest rates
Should you ever use different discount rate for different years in a DCF?
Yes, sometimes it makes sense to use different Discount Rates - if a company is growing quickly right now, but expected to mature and grow more slowly in the future, may use decreasing Discount Rates
Do you still un-lever and re-lever Beta even when you're using Unlevered FCF?
Yes. Company's capital structure affects both COE and WACC - do it regardless of type of cash flow in analysis
How do you calculate the equity risk premium?
almost no agreement on how to do this.. -firms use publication called Ibbotsons" that publishes this data -could use historical data and add a premium based on default spread -could use standard number (6-7%)
How would you estimate the Cost of Equity for a US based tech company?
guesstimate based on common sense and your knowledge of the current market rate. -risk free rate is around 1.5%, Beta may be around 1.5. So if you assume equity risk premium of *% - Cost of Equity would be around 13.5%