Corporate Finance Topics | Issue No. 1 2015
The WACC Hurdle:
Assessing Cost of Capital and Performance
The WACC Hurdle:
Assessing Capital Cost and Performance
This is not an equity research publication. Corporate Finance
Topics is a publication of Bank of America Merrill Lynch’s Corporate
Finance Group. We are committed to helping our clients create
shareholder value by delivering innovative, strategic solutions to
address their most complex financial needs. We deliver the power
of the firm to our clients through a team of experts who draw upon
the broad capabilities of our global, integrated platform.
Introduction
1
The value of a business is a function of the expected cash flows that result from
management deploying capital; however, this capital has a cost. Value is created
to the extent cash flows exceed the costs required to achieve them.
In our Q2 2013 piece,1 we identified a positive correlation between the change
in ROIC and total shareholder return (price return plus dividends) when looking
at the 2008-2012 period. We have re-examined this correlation using the S&P
500 constituents from 2010 to 2014. Based on our analysis, the same correlation
continues. As we look internationally, we also see a similar correlation when
analyzing the companies in the STOXX® Europe 600.
One of the most common ways to calculate the cost of capital is to calculate
a company’s weighted average cost of capital (WACC). However, the inputs are
often debated, and in this piece we will focus on the options available when
calculating WACC.
1
Available at www.bofaml.com/corporatefinance.
Corporate Finance Topics | Issue No. 1 2015
Lessons learned: The strong correlation between change in ROIC and total return
that we reported in our Q2 2013 publication, Calibrating ROIC to Drive Shareholder
Value, continues today. Based on our observation of S&P 500 companies’
performance over the past five years, as illustrated in Figure 1, the higher the
change in ROIC (3.4% for top quartile vs. -2.3% for bottom quartile), the higher
the annualized total return (28.0% for top quartile vs. 4.8% for bottom quartile).
5yr Annual Total Return
30%
Figure 1.
5-Year Annualized Total
Return vs. Change in
ROIC Over Past 5 Years*
2
5%
28.0%
4%
25%
20%
3.4%
3%
19.2%
15%
1%
13.7%
10%
0%
(0.0%)
5%
0%
2%
4.8%
(1.2%)
(2.3%)
Top Return
Quartile
2nd Return
Quartile
5yr Annual Total Return
3rd Return
Quartile
(1%)
5yr Change in ROIC
1
Revisiting ROIC
(2%)
(3%)
Bottom Return
Quartile
5yr Change in ROIC
Through our analysis and multiple discussions with our clients, we have learned
three key lessons for firms evaluating ROIC:
1. Recognize steady state ROIC: For many companies, base case ROIC may be
decreasing, despite projected strong operational performance (e.g., as a result of
capital intensity increasing). Companies must identify the true required capital
for a given level of steady state profitability.
2. ROIC is volatile: While increasing ROIC is correlated with higher total returns,
our analysis also shows that ROIC does not need to permanently improve. Like
all financial metrics, ROIC is expected to go through volatile periods, especially
when growth projects are pursued. Companies experiencing decreasing ROIC
year over year need to identify the reasons behind the trend. If ROIC decreases
are attributable to other benefits, such as growth initiatives, then a temporary
decline can be viewed positively.
3. Always manage the portfolio: A company’s portfolio of assets must be
actively managed into perpetuity. Companies should perform a periodic review
of all assets, including an analysis of separating subsidiaries, growth initiatives
and return of excess cash. Consistent deployment of capital and ongoing
reduction of underperforming capital bases should form a permanent part
of a company’s strategy.
*Source: FactSet
Corporate Finance Topics | Issue No. 1 2015
2
WACC basics
3
The weighted average cost of capital (WACC)2 is a common means of assessing a
company’s cost of capital. WACC is based on a company’s cost of equity and taxeffected cost of debt, with each cost weighted in proportion to its contribution to
the overall capitalization of the business.
While the formula for calculating WACC is generally accepted, there are several
schools of thought regarding how each underlying component should be calculated.
Outstanding Questions
Risk-Free Rate
Cost of Debt
Current vs. Normalized Long-Term Treasury Yields
Current vs. Normalized
Blended vs. Marginal Cost of Debt
Equity Risk
Premium
Beta
Geometric vs. Arithmetic Mean
Bloomberg Beta vs. Barra Beta
Company’s Beta vs. Comparable Betas
Risk-free rate: Both the cost of debt and cost of equity calculations factor in
the risk-free rate. Practitioners often base the risk-free rate on U.S. government
treasury bond rates, given the minimal amount of default risk. Because companies
are valued based on the business’s cash flows over the long term, there is general
agreement that the risk-free rate used to value the cash flows should similarly be
based on long-term rates.3 Specifically, some practitioners will say the risk-free rate
term should be consistent with the equity risk premium applied. However, shorter
term bonds may be appropriate for companies valuing a cash flow stream with a
finite life.
A bigger debate surrounds the use of current treasury rates vs. a historical average.
Some practitioners argue current rates are reflective of the best and latest market
views and should be used as is.
Others believe rates are temporarily low and are artificially depressed due to
government intervention; these practitioners argue a longer-term historical
average should be used. Currently, a 20-year treasury bond yields 2.39%, which
is significantly under the 10-year average yield for the 20-year of 3.90%. In
deciding whether to normalize, we believe companies need to apply consistent
treatment, factoring the same risk-free rate assumption (and implicit economic
growth assumption) into the cost of capital calculations and the cash flows being
discounted. For example, if low current risk-free rates are reflective of lower growth
and lower inflation, projected cash flows should reflect the same.
2
For purposes of these materials, WACC is calculated as
(Debt/Capitalization * (Cost of Debt * (1 - Tax Rate))) + (Equity/Capitalization * Levered Cost of Equity).
3
Bank of America Merrill Lynch investment banking utilizes 20-year treasury rates.
Corporate Finance Topics | Issue No. 1 2015
4
Cost of debt: The cost of debt is also subject to the same normalization question
as the risk-free rate. In addition, there is also the question of whether to utilize the
marginal or blended cost of debt. To the extent a cost of capital analysis is being used
to measure incremental cash flows from incremental investment, the marginal cost of
debt is most appropriate. Bank of America Merrill Lynch investment banking typically
utilizes the overall blended cost of an unsecured long-term (10-year) note. Further, it
is best practice to base the cost of debt on the company or assets being valued.
Equity risk premium: The expected equity risk premium represents an estimate
of the excess return investors expect from taking on additional risk of investing
in equity securities, as opposed to risk-free government bonds. The equity risk
premium is generally based on a long history of data, given the cyclical nature of
market returns. By using long-term returns, practitioners can avoid the seemingly
random forecasts that short-term observations often produce.
The equity risk premium can be calculated by using either a geometric or arithmetic
mean of historical returns. The arithmetic average represents a simple average
of annual returns over a given period. The geometric average represents the
compounded return achieved over the same period, assuming reinvestment; it
reflects the return achieved had the investor hold the stock over the given time
period. For the 1926-2013 period, the equity risk premium’s geometric and arithmetic
means were 4.99% and 7.00%, respectively. For long-term, going-concern companies,
a geometric average would be more reflective of the return required by a long-term
investor. However, some view arithmetic risk premiums as more appropriate, given no
correlation between equity returns from one year to another.
Beta: The beta used in WACC calculations should estimate the risk of a
company’s future performance relative to the broader market. There are two
main sources for beta and each has its own merits based on the facts and
circumstances of the analysis.
1. Barra beta: The Barra predicted beta model is a multivariate model that
includes numerous factors impacting a company’s performance and risk
profile. Risk factors attributed to incremental equity risk premia are embedded
within the Barra predicted beta model, including a company’s size, currency
exposure, volatility, momentum, and financial performance.4 Barra re-estimates
a company’s exposure to underlying risk factors monthly in an effort to reflect
changes in the company’s underlying risk structure.
2. Bloomberg adjusted beta: Bloomberg betas are based on a historical
regression of a stock’s excess returns against an index. The betas are based on
observations across a specific time period that can be adjusted. The historical
time period chosen should balance recency with sufficient and relevant data
4
Barra beta is derived from fundamental risk factors, which include 16 attributes for long-term investment horizons: value,
profitability, growth, leverage, earnings quality, management quality, dividend yield, earnings yield, momentum, liquidity,
beta, residual volatility, long term reversal, prospect, size and mid capitalization.
Corporate Finance Topics | Issue No. 1 2015
points; monthly observations over five years are often used. However, if there is
a significant event in the company’s history (i.e., acquisition, divestiture, spinoff, change in business model, etc.), the beta observations should be taken as
of a date subsequent to the event. Bloomberg adjusts the historical data by
assuming companies’ betas will move toward the market average.5 Bloomberg
adjusted betas with low regression coefficients should also be eliminated, as
seen in Figure 2.6
Statistic
Figure 2.
Beta Statistics**
Barra Beta
1.16
Bloomberg
Statistics
Beta
R2
Monthly
0.88
0.11
Weekly
0.96
0.22
Daily
1.01
0.26
Barra betas have the benefit of factoring in size, volatility and financial
performance, while Bloomberg betas only factor in historical data. However, the
merits of each approach are based on the facts and circumstances of the analysis.
Our proposed framework for choosing the appropriate beta is illustrated in Figure 3.
Generally, a public company’s own Barra beta should be used. However, the average
of an appropriate set of comparable companies may be used if there is a significant
change in the company’s business (i.e., acquisitions, divestitures, spin-offs, or changes
in business model, capital structure or liquidity). Because Barra betas include a size
premium, adjusted Bloomberg betas should be used in combination with appropriate
size premiums when using comparable companies of different size.
Comps
different size
Am I a Private Company,
Division, Public Company
with Volatile Trading
History,7 or Micro Cap?
Yes
Comparable
Companies Analysis
No
Use Company’s
Barra Beta
Comps
similar size
Use Adjusted
Bloomberg Beta,
Size Premiums and
Country Premiums
(as appropriate)
Use Barra Betas
Figure 3.
Choosing a Beta
5
**Source: MSCI Inc. and Bloomberg.
5
Bloomberg adjusted beta is calculated as 67% * Raw beta + 33% * 1.0.
6
Represents actual Barra and Bloomberg betas for a specific company as of a specific date.
Trading subject to unique or unusual circumstances (e.g., limited liquidity, large control blocks, takeover speculations, lack
of institutional investment and stock research sponsorship, extreme leverage, recent emergence from bankruptcy etc.).
7
Corporate Finance Topics | Issue No. 1 2015
6
Hypothetical analysis: Based on the wide range of inputs available when calculating
WACC, practitioners can arrive at vastly different cost of capitals for the same firm.
For example, a firm is capitalized with 20% debt and 80% equity using the beta
statistics in Figure 2. Additionally, assume the firm has a 3.5% cost of debt spread
over treasury yields.
By varying the treasury yield, beta, and equity risk premium assumptions for this
firm, we find that WACC varies significantly, ranging from 6.7% to 10.6%. Thus, a
sensitivity analysis that incorporates a range should be performed as part of any
cost of capital analysis.
Assumptions:
Current2.4%
Treasury Yield
Normalized3.9%
Bloomberg0.88
Beta
Barra1.16
Equity Risk Premium
Geometric5.0%
Bloomberg0.6%
Size Premium 8
8
Arithmetic7.0%
Barra0.0%
Treasury Yield
Beta
Equity Risk
Premium
Normalized
Barra
Arithmetic
Normalized
Bloomberg
Arithmetic
Current
Barra
Arithmetic
Normalized
Barra
Geometric
Current
Bloomberg
Arithmetic
8.1%
Normalized
Barra
Geometric
8.1%
Current
Barra
Geometric
Current
Bloomberg
Geometric
WACC
Size premium assumes company’s equity value between $10.1bn and $24.3bn.
Corporate Finance Topics | Issue No. 1 2015
10.6%
9.5%
9.2%
8.7%
7.3%
6.7%
3
International
WACC
Figure 4.
Accounting for
International Risk
7
The global financial crisis demonstrated potential for dramatic and rapid shifts
in country-specific financial risks. Further, the crisis showed that country risk
calculated from traditional models may be disconnected from the perceived “real”
risk of businesses. As seen in Figure 4, companies can use two alternative methods
for capturing risk in international investments: (1) adjusting cash flows or (2)
adjusting discount rates.
Accounting for risk in
international investments
– Inflation
– Country-specific
Adjust cash flows
Local/Single
Country CAPM
Adjust discount rate
Sovereign
Spread
The preferred method to account for international investment risk is to adjust cash
flows, as managers often have better insight into how risks will impact expected
cash flows. Local cash flows would be translated at the expected exchange rates
(to account for inflation) and then probability-weighted for other country-specific
risks. The resulting cash flows would then be discounted using a U.S.-based WACC.
However, when that is not possible, there are various ways to account for risks in
the WACC.
International cost of equity: International risk can be incorporated into the cost
of equity calculation and we highlight two methods here: (1) local/single country
CAPM and (2) sovereign spread.
1. Local/single country CAPM: This analysis uses local inputs to determine the
appropriate local cost of equity.
re = rf + β * MRPlm
•rf: Local risk-free rate
•β: Correlation to local market
•MRPlm: Local equity market risk premium
•Note: If all return estimates in local currency, discount rate applicable to local
currency cash flows, with resulting present value then translated to today’s
exchange rate
In theory, the local/single country CAPM method is preferred, as local inputs should
provide the best reflection of local risks. In practice, markets outside the U.S. do
not have a long history of efficient, established and liquid trading and thus may not
provide statistically relevant inputs.
Corporate Finance Topics | Issue No. 1 2015
8
2. Sovereign spread: This approach combines the benefits of developed market
inputs for the calculation of the base WACC with an adjustment to account for
country-specific risks.
re = rf + (β * MRPdm) + MRPlm
•rf: Home (EUR/USD) risk-free rate (developed markets)
•β: Correlation to developed markets
•MRPdm: Developed equity market risk premium
•MRPlm: Regional equity market risk premium
The regional equity market return premium is calculated by first taking the yield
differential of the local country’s local currency denominated government bond vs.
a developed country’s bond, which accounts for certain country-specific risks. This
debt-based figure is then translated into an equity-based number by multiplying the
debt yield differential by the volatility of the local equity market relative to the local
bond market.
MRPlm = dls * (els/bls)
•dls: Bond default spread proxy to measure country risk
–Default spread measures default risk rather than equity risk; sovereign
bonds are affected by the same factors that drive equity risk, i.e., political
and currency stability
•els: Standard deviation of local equity market
•bls: Standard deviation of local bond market
This latter adjustment is largely limited to markets that have a history of bond
and equity market returns. Absent established markets, the bond yield differential
is simply added without the equity vs. debt volatility factor. It is also important to
use bond and equity markets that are denoted in local currency.
Cash flow vs. WACC adjustment: In theory, if risks are properly accounted
for, adjusting cash flows should result in the same present value as adjusting
WACC. Similar to checking the implied perpetuity growth rate when using EBITDA
multiples to calculate a terminal value in a discounted cash flow analysis, one can
calculate the implied local discount rate after adjusting cash flows. We illustrate a
simple example in Figure 5 to account for inflation risks.
Corporate Finance Topics | Issue No. 1 2015
Illustrative Foreign vs. U.S. Cash Flows
Year
2014F
2015F
2016F
2017F
…
2024F
$100
$110
$121
$133
…
$259
10.0%
10.0%
10.0%
…
10.0%
10.0%
10.0%
…
10.0%
Inflation Rate (U.S.)
1.5%
1.5%
…
1.5%
PPP Adjustment Factor
1.08
1.08
…
1.08
9.98
10.82
…
19.00
Cash Flows (Foreign)
% Growth
Inflation Rate (Foreign)
Exchange Rate Forecast
8.50
9.21
----->>>>> PPP Exchange Rate Forecast
Adjust Cash Flows
Year
Cash Flows (USD)
2014A
2015F
2016F
2017F
…
2024F
$12
$12
$12
$12
…
$14
$11
$10
$9
…
$5
2014A
2015F
2016F
2017F
…
2024F
$100
$110
$121
$133
…
$259
$92
$85
$79
…
$45
Present Value (at U.S. WACC)
Total Present Value (USD)
$78
Implied WACC
Year
Cash Flows (Foreign)
Local WACC
19.2%
Present Value
Total Present Value
(in Foreign Currency)
Exchange Rate
(USD / Foreign Currency)
Total Present Value (USD)
Implied International
Risk Premium
$660
8.50
$78
9.2%
Assumptions:
Foreign Inflation
U.S. Inflation
Figure 5.
Illustrative Foreign
vs. U.S. Cash Flows
9
Exchange Rate
U.S. WACC
9
10.0%
1.5%
Purchasing Power Parity 9
10.0%
Based on PPP, the expected exchange rate is a function of the current exchange rate and the expected inflation differential,
calculated as follows: eexpected = ecurrent spot* (1+iFOR) / (1+ iUSD); where eexpected is the forecast or expected exchange
rate, ecurrent is the current spot exchange rate, iFOR is the expected inflation rate for the foreign country and iUSD is the
expected inflation rate for the domestic (USD) country.
Corporate Finance Topics | Issue No. 1 2015
4
Conclusion
10
Companies that have the most improvement in their ROIC generally also have
the best total shareholder return. A key consideration in determining which valuemaximizing projects to invest in is cost of capital. In theory, a greatly improving ROIC
should only maximize value if the cost to achieve the improvement is lower than
the improvement itself. WACC is one of the most commonly accepted methods of
calculating cost of capital, but debate continues over how certain WACC inputs are
calculated. When to use different types of beta and how to adjust for international
risk in a company’s cost of equity are two inputs that are highly situation-specific,
and each methodology has legitimate benefits and considerations.
Given the lack of consensus over how to calculate WACC, it is important to include
a sensitivity analysis with a range of costs as part of any cash flow discounting
exercise. Moreover, as it relates to international WACC, a useful exercise is to
project cash flows, adjusted for various risks, and cross-check the implied discount
rate with the discount rate that was derived using the WACC method.
Corporate Finance Topics | Issue No. 1 2015
For more
information,
please contact:
Souren Ouzounian
Head of Americas Corporate Finance
souren.ouzounian@baml.com
646.855.5300
Jay Bliley
jay.bliley@baml.com
646.855.4666
Leonard Chung
leonard.chung@baml.com
310.209.4062
bofaml.com/corporatefinance
Amir Mirza
amir.mirza@baml.com
646.855.4331
Philip Turbin
philip.turbin@baml.com
646.855.4708
Gus Garcia
g.garcia@baml.com
646.855.4680
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Corporate Finance Topics | Issue No. 1 2015