There are a few issues I have with WACC when I think more deeply, and I wanted to hear your opinions about it. Sorry if the post is a bit long.
We all agree on how WACC could be seen as an opportunity cost (i.e. the return on next best thing, what you could alternatively do with your funds), however I fail to grasp which perspective should I be taking when I see WACC as an opportunity cost.
What I mean by that is; if I am acquiring a company, I am coming up with a WACC using cost of equity and cost of debt assumptions. From the cost of equity perspective I can understand that, because it essentially is my required rate of return - otherwise I would go and invest in alternatives. So if the target is riskier I am attaining a higher risk premium - my required return is higher.
But from the cost of debt perspective I fail to understand this. Why would we use the cost of debt assumptions of the target (or peers if any) if we are looking at the opportunity cost from our perspective?
In fact, if this is an opportunity cost what does it have to do with capital structure at all? (My company’s or the target’s).
Therefore why would we need a debt/equity ratio (of our company or target’s) from the opportunity cost perspective.
Second, when determining the WACC, what D/E ratios shall we use? For instance when valuing a company, should we use their current (or target) D/E ratios or use industry median from peers?
And let’s assume we are trying to find the Equity Value of the company, indirectly using FCFF and discounting it with WACC, then adjusting for net debt.
Well does not that create a circularity in the sense that, if I use companys existing equity/debt mix, and then use this D/E mix in WACC in order to get the Equity Value (indirectly), which basically is what has to be used in WACC D/E ratio?
Am I missing something here, or how is it done in practice?
And if the usage of industry median D/E is advised, well then how do we get to the same
Equity value; when we are calculating it indirectly from FCFF and WACC and when we calculate it directly from FCFE and Cost of Equity. What I mean by that is, if industry median D/E is used, my WACC calculation discounts those FCFF accordingly however I will be deducting the company’s own debt in order to get to the equity value. Would that be consistent with my direct equity value calculation?
And finally If I am acquiring a company, do I still use my target’s D/E mix? Because again from the opportunity cost perspective I fail to see what kind of relevance the capital structure of the target is having.
Sorry again for the length, and while it might be a bit unclear what I tried to explain, I can elaborate it further if you point it out.
Before I answer your question regarding WACC, I would like to point one flaw in yoir argument which you made regarding the higher cost of equity ( From the cost of equity perspective I can understand that, because it essentially is my required rate of return - otherwise I would go and invest in alternatives. So if the target is riskier I am attaining a higher risk premium - my required return is higher.) : If your target is risker, your Beta would be higher and not the risk premium. The risk premium would depend on where your operations are based and from where you draw revenues. If your target is based out of Nigeria, you would demand higher risk premium than its based in developed markets. Going back, If your target is riskier because it has huge financial leverage, the levered beta of the target would tend to be very high thus raising your cost of equity. Regarding cost of debt : Its the rate at which you borrow long term today. The key word is today. So your target might have borrowed billion dollar at low interest rate 4 years ago ( say 0.5%) but lets say the risk free rate in USD is 2% now, If you consider book interest rate of 0.5%, you would require the projects funded with the capital earning more than 0.5% to be a good investment. Because you can invest in Treasury bonds and get 2% without taking any risk, this is clearly not a high enough hurdle rate. Hence cost of debt has to be a part of the oportunity cost of investing
regarding D/E, it depends on the stage of your company. If your company is a young company/ growth stage they do not have enough cash flows or earnings to pay interest expenses. You can take the current D/E and allow for the fact thattthe debt ratio of teh firm will probably increase overtime towards industry average.Mature firms sometimes decide to change their financing strategies, pushing toward target debt ratios that are much higher or lower than current levels. When analyzing these firms, we should consider the expected changes as the firm moves from the current to the target debt ratio. In my valuation, I use current D/E of the company and I converge the D/E to industry when it reaches steady state.
3.Hope the answer to #2, solves your problem?
When you are acquiring a company, first of all it should be clear if you are using FCFF or FCFE. If you use FCFE, you would use cost of equity of the target, if you use FCFF you would use cost of capital of the target and hence target’s D/E. If you are a safe company and the target is riskier (has lot of debt),you would use target’s D/E to take into consideration the effect of leverage. Hence , capital structure does matter