5 views

Uploaded by Shito Ryu

Applicability of the Classic WACC Concept in Practice

- End Sheets
- Valuation Report
- Assignment 03
- Exploration Economics 2004
- 2
- Cost of Capital
- DCF Template S2018
- FINANCIAL MANAGEMENT ( MBA )
- Project management
- Twou Short Idea
- CCOLA0109
- Managing Finincial Principles & Techniques Ms.safina
- Evaluating Flexibility
- 284595216-Natureview-Farm-Case-Analysis.xlsx
- Fin 600_Radio One-Team 3_ Final Slides
- DONE - Reference- Esaa16_public
- 10 DCA 2
- Nice Looking Report
- Q4
- 12221-14573-1-PB

You are on page 1of 22

M. A. Mian

Downloaded by [Instituto de Economia - UFRJ], [Lucilia Silva] at 13:59 06 August 2013

Ignacio Vélez-Pareja

flow (DCF) approach as the primary technique for investment/project

evaluation and the capital budgeting process. This approach requires

forecasting the detailed cash flow of the project under evaluation and

then discounting the resulting cash flow to the present value (Net Pres-

ent Value–NPV) using an appropriate discount rate.

The discount rate commonly used represents the Weighted Average

Cost of Capital (WACC) of the firm. There is no scarcity of literature on

this subject as the concept has been around for the last 50 years or so. Al-

though most analysts believe the concept is simple and very well known,

the irony is that its misinterpretation and misuse prevails. There are

many versions of the WACC equation and each is specific to a certain

cash flow. Therefore, using the classic WACC relationship in all cases

may result in the calculation of an overly optimistic NPV. Depending on

the cash flow pattern, the investment may show a positive NPV at the

classic WACC but it will actually be losing equity.

This paper highlights (a) pitfalls and misuses of the WACC, (b) inter-

dependence between types of cash flow and WACC, (c) assumptions be-

hind the WACC and whether these assumptions are realistic, and

(d) alternative approaches to arrive at the correct net present value

(NPV). Company CEOs, management, analysts, and other investors us-

years of international experience in petroleum engineering (E-mail: mohammad.mian@

aramco.com).

Ignacio Vélez-Pareja, Finance Professor at Universidad Tecnologica de Bolivar,

Cartagena, Colombia, has more than 40 years in teaching and management in private

firms (E-mail: nachovelez@gmail.com).

Latin American Business Review, Vol. 8(2) 2007

Available online at http://labr.haworthpress.com

Ó 2007 by The Haworth Press. All rights reserved.

doi:10.1080/10978520802084123 19

20 LATIN AMERICAN BUSINESS REVIEW

ing the WACC for investment decisions need to be fully aware of its pit-

falls and misuses.

de caja descontado (DCF–discounted cash flow), como la técnica princi-

pal para evaluar las inversiones/proyectos y el proceso de elaboración

Downloaded by [Instituto de Economia - UFRJ], [Lucilia Silva] at 13:59 06 August 2013

del flujo de caja del proyecto bajo análisis y, a continuación, el redescuento

del flujo de caja resultante al valor actual–Valor Actual Neto (Net Pres-

ent Value–NPV) utilizando una tasa de redescuento apropiada.

La tasa de descuento comúnmente utilizada representa el Costo de

Capital Medio Ponderado (Weighted Average Cost of Capital (WACC)

de la empresa. No falta literatura a este respecto, ya que el concepto

ha existido ya alrededor de 50 años. Aunque la mayoría de los

analistas creen que el mismo es simple y muy conocido, irónicamente,

lo que prevalece es su mala interpretación y uso equivocado. Existen

muchas versiones sobre la ecuación WACC, y cada una se identifica

con un flujo de caja específico. Consecuentemente, el uso de la relación

WACC clásica puede resultar, en todos los casos, en un cálculo de NPV

exageradamente optimista. Dependiendo del tipo de flujo de caja, la

inversión puede mostrar un NPV positivo con un WACC clásico, cuando

en realidad estará perdiendo patrimonio.

Este documento coloca en destaque (a) escollos y mal uso del

WACC, (b) interdependencia entre el tipo de flujo de caja y el

WACC, (c) presunciones por detrás del WACC, y si ellas son realistas, y

(d) mostrar enfoques alternativos para llegar al valor actual neto correcto

(NPV). El CEO de la empresa, su gerencia, analistas y otros inversores

usarán el WACC para tomar decisiones inherentes a la inversión.

fluxo de caixa descontado (DCF) como técnica básica de avaliação de

investimentos/projetos e do processo de orçamentação de capital. Essa

abordagem requer que se preveja o fluxo de caixa detalhado do projeto

sob avaliação e, depois, desconte o fluxo de caixa resultante para obter o

valor presente líquido (NPV) usando uma taxa de desconto apropriada.

A taxa de desconto geralmente usada representa o Custo de Capital

Médio Ponderado (WACC–Weighted Average Cost of Capital) da empresa.

A literatura sobre este tema é abundante, já que o conceito existe há uns

50 anos. Embora a maioria dos analistas considere o conceito simples e

bem conhecido, o fato é que erros de interpretação e utilização predominam.

Existem muitas versões da equação do WACC, cada uma específica a

certo fluxo de caixa. Portanto, aplicar a relação WACC clássica a todos

os casos pode resultar em cálculos de NPVs otimistas demais. Dependendo

M. A. Mian and Ignacio VUlez-Pareja 21

no WACC clássico, quando na verdade estará perdendo patrimônio.

Este artigo realça (a) as armadilhas e usos equivocados do WACC,

(b) as interdependências entre tipo de fluxo de caixa e WACC,

(c) pressupostos por trás do WACC e se esses pressupostos são realistas,

e (d) mostra abordagens alternativas para se chegar ao valor presente líquido

Downloaded by [Instituto de Economia - UFRJ], [Lucilia Silva] at 13:59 06 August 2013

investidores que usam o WACC nas decisões de investimentos. doi: 10.1080/

10978520802084123 [Article copies available for a fee from The Haworth Document De-

livery Service: 1-800-HAWORTH. E-mail address: <docdelivery@haworthpress.

com> Website: <http://www.HaworthPress.com> Ó 2007 by The Haworth Press. All

rights reserved.]

INTRODUCTION

approach as the primary technique for investment/project evaluation

and the capital budgeting process. This approach requires forecasting

the detailed cash flow of the project under evaluation and then discount-

ing the resulting cash flow to the present value (Net Present Value-

NPV) using an appropriate discount rate.

The discount rate commonly used represents the Weighted Average

Cost of Capital (WACC) of the firm. There is no scarcity of literature on

this subject as the concept has been around for the last 50 years or so.

Although most analysts believe the concept is simple and very well

known, the irony is that its misinterpretation and misuse prevails. There

are many versions of the WACC equation and each is specific to a cer-

tain cash flow. Therefore, using the classic WACC relationship in all

cases may result in the calculation of an overly optimistic NPV. De-

pending on the cash flow pattern, the investment may show a positive

NPV at the classic WACC but it will actually be losing equity.

This paper highlights (a) pitfalls and misuses of the WACC, (b) inter-

dependence between types of cash flow and WACC, (c) assumptions

behind the WACC and whether these assumptions are realistic, and

(d) alternative approaches to arrive at the correct net present value

(NPV). Company CEOs, management, analysts, and other investors using

WACC for investment decisions need to be fully aware of its pitfalls and

misuses.

Introduction

A large percentage of companies use the discounted cash flow (DCF) approach as the primary

technique of investment/project evaluation and capital budgeting process. This approach requires

forecasting detailed cash flow of the project under evaluation and then discounting the resulting

cash flow to the present value (Net Present Value – NPV) using an appropriate discount rate.

The discount rate commonly used represents the Weighted Average Cost of Capital

(WACC) of the firm. There is no scarcity of literature on this subject as the concept has been

around for the last 50 years or so. Although most analysts believe the concept is simple and very

well known, the irony is that its misinterpretation and misuse prevails. There are many versions

of the WACC equation and each is specific to a certain cash flow. Therefore, using the classic

WACC relationship in all cases may result in calculation of overly optimistic NPV. Depending

on the cash flow pattern, the investment may show positive NPV at the classic WACC but it will

actually be loosing on equity.

This paper highlights the (a) pitfalls and misuse of the WACC, (b) interdependence

between type of cash flow and WACC, (c) assumptions behind the WACC and whether these

assumptions are realistic, and (d) shows alternative approaches to arrive at the correct net present

value (NPV). The company CEOs, management, analysts, and other investors using WACC for

investment decisions need to be fully aware of its pitfalls and misuse.

A Review

The interactions between the market value of cash flows and the discount rate (usually the

WACC) to calculate the levered value is a well known problem. (See Myers, 1974). It is

mentioned in almost all textbooks in corporate finance. However, the typical solution offered by

most authors is to assume a constant discount rate which implies a constant leverage D%, and

hence assume that the constant leverage correspond to an optimal capital structure. On the other

hand, most authors use the definition of the Ke, the cost of levered equity for perpetuities even if

the planning horizon is finite. Among these authors we find the work of Wood and Leitch W&L

2004. Vélez-Pareja and Tham, 2005 debate this paper.

Vélez-Pareja and Tham (2000), Tham and Velez–Pareja, 2002, Vélez-Pareja and Burbano

2005, Tham and Velez–Pareja, 2004b, Velez-Pareja and Tham, 2005, have shown and proposed

a very simple manner to tackle the issue of circularity. Mohanti, 2003, proposes an iterative

method to solve the issue. Wood and Leitch 2004, (W&L) propose an iterative and approximate

method to solve this circularity.

When we review the literature on this subject we find that either the authors elude the

problem of matching the results using different methods, or use perpetuities (that is a form to

elude the problem), or use very simple example (one period), or simply they say that differences

are not relevant. Taggart 1991, Vélez-Pareja and Tham (2000), Tham, and Velez–Pareja, 2002,

Applicability of the Classic WACC Concept in Practice

Vélez-Pareja and Burbano 2005 and Tham, Velez–Pareja, 2004a and 2004b, have derived

independently the expression for Ke when there are finite cash flows.

In the best reputed textbook in corporate finance, (Brealy, Myers and Allen (BMA) 2006,

8th edition) referring to an example with finite cash flows where APV and FCF methods do not

match (BMA, 2006, page 523):

“… If the debt levels are taken as fixed, then the tax shields should be discounted

back at the 6 percent borrowing rate.

[…] The increase [in value] can be traced to the higher early debt levels and to the

assumption that the debt levels and interest tax shields are relatively safe.” (There is a

foot note that says: “But will Rio really support debt shown […]? If not, then the debt

must be partially supported by Sangria’s [the firm that would buy Rio] other assets,

and only part of the 5 millions in PV(interest tax shields) can be attributed to Rio

itself”.)

On page 524, they say: “Now a difference of 1.4 million is not a big deal considering

all the lurking risks and pitfalls in forecasting Rio’s free cash flows. But you can see

the advantage of the flexibility APV provides. The APV spreadsheet allows you to

explore the implications of different financing strategies without looking into a fixed

debt ratio or having to calculate a new WACC for every scenario.

APV is particularly useful when debt for a project or business is tied to book value or

has to be repaid on fixed schedule”.

In Vélez-Pareja and Tham, 2006, they show that the two methods give identical results

using the same example proposed by BMA.

Ross, Westerfield and Jaffre (RWJ), 1999, page 441, say, referring to three methods to

calculate the levered value of a firm for perpetuity:

“The net present value […] is exactly the same under each of the three methods

[PV(FCF at WACC, PV(ECF at Ke) + debt and Adjusted present value, APV].

However, one method usually provides an easier computation than another, and, in

many cases, one or more of the methods are virtually impossible computationally.

[…]

[…] if the debt-to-value ratio remains constant over the life of the project, both rs and

rWACC will remain constant as well. However, if the debt-to-value ratio varies from

year to year, both rs and rWACC vary from year to year as well. Using the FTE [ECF]

or the WACC approach when the denominator changes every year is computationally

quite complex, and when computations become complex, the error rate rises. Thus,

both the FTE and WACC approaches present difficulties when the debt-to-value ratio

changes over time.”

Copeland, Koller and Murrin, 2000, (page 148) say “You may have noted that the

enterprise value of operations does not exactly match that given by the APV approach. The

difference is about 2 percent. The enterprise DCF model assumes that the capital structure (the

Applicability of the Classic WACC Concept in Practice

ratio of debt to debt plus equity in market values) and WACC would be constant every period.

Actually the capital structure changes every year.”

Benninga and Sarig, 1997, (page 418) when the values of equity under different methods

do not match, say: “As you can see, the results of the two valuations are very close. The

differences are caused by the fact that we have used cost of capital formulas for no-growth,

infinitely lived models to do the valuation job in our pro-forma framework, in which cash flows

are projected to grow.”

We have mentioned the most popular books on valuation and we can see that either they

do not solve the problem of matching the values under different methods or simply they elude it.

In this paper we show how to solve this and show that the matching of values calculated under

different methods is possible and very easy to do.

The weighted-average cost of capital (WACC), as the name implies, is the weighted average of

the firm’s overall capital structure, i.e., its cost of equity (KE) and its cost of debt (KD). For the

purpose of this paper it is assumed that the firm’s cost of equity and cost of debt have been

already calculated using the acceptable financial techniques, such as the Capital Asset Pricing

Model (CAPM). Some analysts misinterpret the WACC as synonym of CAPM. This is not

correct, they are not synonyms. The WACC is just an algebraic manipulation to combine the KE

and KD into their respective proportion, reflecting the capital structure of the firm. The most

classic forms of the WACC are shown below.

After-tax WACC

WACC AT = WE × K E + WD × K D (1 − Tc ) (1)

Before-tax WACC

WACC BT = WE × K E + WD × K D (2)

Where WE is the weight of equity related to the value of the firm, KE is the levered cost of

equity, WD is the leverage related to the value of the firm, KD is the cost of debt and Tc is the

corporate tax rate.

Under certain assumptions we can call the WACCBT as the WACC for the Capital Cash

Flow (CCF). The two equations above define the WACC in terms of the variables shown in

Table 1. In that table we show the numbers for an illustrative example.

Applicability of the Classic WACC Concept in Practice

Expected Market Risk Premium K mp 6.40%

Systematic Market Risk, Levered Beta (from CAPM) βL 0.71

Unlevered Beta, β UL = β L (1 + WD ) β UL 0.57

Credit Risk Premium βD 0.7%

Corporate Tax Rate Tc 35%

Debt-to-Value Ratio WD 25%

Equity-to-Value Ratio WE 75%

Cost of Levered Equity, K L E = K F + K mp × β L KLE 10.0%

Cost of Unlevered Equity, K ULE = K F + β UL × K mp K UL E 9.10%

Cost of Debt, K D = K F + β D KD 6.15%

The classic WACC (WACCAT) equation is basically composed of three parts. The first part

(WE x KE) represents the equity portion of the cash flow, the second part (WD x KD) represents the

debt portion of the cash flow, and the third part (1 – Tc) in the second term of Equation (1)

adjusts the interest payment for the tax benefit due to the tax-deductible interest payments. The

WACCAT and WACCBT for the data in Table 1 are calculated as shown below.

The WACC represents the expected return on a portfolio of all the company’s securities,

i.e. equity and debt. This rate is applied to project cash flows — cash flows excluding the cash

outflows due to financing (i.e., interest payment, principal payment or the tax benefit created due

to the tax deductible interest payments when derived indirectly). The side effects of the project

financing are instead bundled in the WACC.

The reason for defining various cash flow streams is that there is interrelationship between the

type of cash flow and the corresponding WACC. The difference between the various cash flows

is solely in their treatment of the value of leverage. This is a very crucial point, which is always

overlooked. This point has significant implications with respect to the definitions of the cost of

capital, cost of equity, and cost of debt. Ignoring this point leads to considerable confusion and

potential errors in applying the discounted cash flow concept. In fact, this is where most analysts

Applicability of the Classic WACC Concept in Practice

violate the assumptions on which the discounted cash flow concept is based and thus start

misusing it.

The most straightforward and intuitive way to see the differences is to numerically specify a

particular cash flow, with its respective cost of capital, and then compare the resulting

profitability yardsticks from the various cash flow streams. Some of the most commonly

encountered cash flows in text books and journals are, according to Ruback, 1995:

FCF (Free Cash Flow) — as shown in Table 2, FCF assumes a hypothetical all equity capital

structure, i.e., total net cash flow—no disbursement of interest and principal payments to

debt holders. The interest and principal payments and tax benefits due to deductible

interest payments are incorporated in the discount rate (after-tax weighted average cost of

capital, WACCAT) rather than the cash flow. It is the available funds for distribution and

actually distributed among the portfolio of all the company’s securities.

Years 0 1 2 3 4 5

Gross Income 1,000 950 950 900 800

Operating Expenses (100) (95) (95) (90) (80)

Interest Expenses

Depreciation (500) (500) (500) (500) (500)

Taxable Income 400 355 355 310 220

Income Tax @ 35% (140) (124) (124) (109) (77)

Net Income 260 231 231 202 143

Initial Investment (2,500)

Loan Proceeds

Principal Payments

Depreciation 500 500 500 500 500

Free Cash Flow (FCF) (2,500) 760 731 731 701 643

ECF (Equity Cash Flow) — includes debt payments (principal and interest) to debt holders. The

resulting cash flow, as shown in Table 3, is net to the Equity shareholders. This is the

classic cash flow and portrays a true image of the cash balance at the company’s treasury.

Since the debt cash flows are included in the cash flow, the cost of equity (KE) rather than

the WACCAT is used for discounting. Or the other way around, it is the cash flow left from

the FCF after the debt holders are paid out.

Applicability of the Classic WACC Concept in Practice

Years 0 1 2 3 4 5

Gross Income 1,000 950 950 900 800

Operating Expenses (100) (95) (95) (90) (80)

Interest Expenses (43) (35) (27) (18) (9)

Depreciation (500) (500) (500) (500) (500)

Taxable Income 357 320 328 292 211

Income Tax @ 35% (125) (112) (115) (102) (74)

Net Income

Initial Investment (2,500)

Loan Proceeds 707

Principal Payments (130) (134) (145) (150) (148)

Depreciation 500 500 500 500 500

Equity Cash Flow (ECF) (1,793) 602 574 568 540 489

CFD (Cash Flow to Debt holders) — Loan proceeds and Interest and principal payments, to the

debt holders, on the outstanding debt.

CCF (Capital Cash Flow) — cash flow is available to both equity and debt holders. As shown in

Table 4, it includes only the tax benefit of tax deductible interest. Since the tax benefit is

included in the cash flow, the before-tax weighted average cost of capital (WACCBT) is

used for discounting. Or the other way around, it is what the portfolio of all the company’s

securities receives. In other words, it is the sum of the CFD and the ECF.

The differences in the three cash flows, using Table 2 as the Base Case, are highlighted in Tables

3 and 4. All cash flows will incorporate adjustments to transform the accounting recognition of

receipts and disbursements into cash flow definitions. The adjustments include operating

expenditure, capital expenditure, depreciation, depletion if applicable, amortization, changes in

working capital, and any other cash or non-cash expenses. The only difference is in the treatment

of CFD. The non-cash expenses such as depreciation, amortization, depletion, and loss carry

forward etc. are subtracted from the taxable income and then added back to the Income after Tax.

The capital cost and changes in working capital are subtracted from the Income after Tax only.

Applicability of the Classic WACC Concept in Practice

Years 0 1 2 3 4 5

Gross Income 1,000 950 950 900 800

Operating Expenses (100) (95) (95) (90) (80)

Interest Expenses

Depreciation (500) (500) (500) (500) (500)

Taxable Income 400 355 355 310 220

Income Tax @ 35% (140) (124) (124) (109) (77)

Net Income 260 231 231 202 143

Interest Tax Savings (ITS) 15 12 10 6 3

Initial Investment (2,500)

Loan Proceeds

Principal Payments

Depreciation 500 500 500 500 500

Capital Cash Flow (CCF) (2,500) 775 743 741 708 646

Table 5 summarizes the type of cash flow and the corresponding discount rate to be used.

CFD Cost of Debt, Kd Market Value of Debt

ECF Cost of Levered Equity, KLE Market Value of Equity

FCF WACCFCF Levered Market Value of Firm

FCF Cost of Unlevered Equity, KULE Unlevered Market Value of Firm

TS Appropriate Discount Rate for TS, Ψ Market Value of the TS

CCF Appropriate Discount Rate for CCF Levered Market Value of Firm

Remember that the definition of the weighted average cost of capital depends on the definition of

the cash flow stream. Therefore, the correct execution of the concept of WACC becomes critical.

For example, using the definition of cash flow from one approach and the cost of capital

from an alternative approach will not give correct value of the project under evaluation. Many

experienced analysts have committed these mistakes so the matter is not trivial.

Applicability of the Classic WACC Concept in Practice

The NPV for all the three cash flows in Tables 2 to 4 calculates to $327 provided the right

combination of cash flows and discount rate is used and all the assumptions are met. The right

combination is, of course, discounting the FCF by WACCAT, the ECF by KLE, and the CCF by

WACCBT. Using the WACCAT with ECF and CCF will give NPV’s of $408 and $366,

respectively. These NPV’s are 25% and 12% higher than the correct NPV of $327.

However, this has solved only one problem, i.e. the NPV calculation. What about the other

profitability indicators? Does IRR of the FCF in Table 2 recognize that the equity is leveraged?

The answer is no, not at all. Similarly, all other profitability indicators will be different. The FCF

is equal to the after-tax cash flow of an otherwise identical project with no debt. The IRR reflects

the return on equity; it has to be calculated with the ECF.

Beside the interrelationship between the cash flows and WACC, the approach is based on the

following assumptions (see Tham and Vélez-Pareja, 2004, Vélez-Pareja and Tham 2000 and

Vélez-Pareja and Burbano, 2005).

1. The D/V ratio is based on the market value of the investment and not the book value. The

market value of equity and the market value of debt refer to the equity and debt

proportion of the market value (V) of the firm, respectively, so that WE + WD = 100%.

The market value is the discounted value (discounted at the WACCAT) of the FCF.

Therefore, V is not the book value, the amount invested, or the project cost as it is most

commonly interpreted. This is a very crucial assumption of the WACC concept. The

market value of debt and the corresponding interest and principal payments (CFD) for the

cash flow in Table 3 are calculated as shown in Table 6.

Table 6. Cash Flow to Debt Holders (CFD) – Constant Debt-to-Value Case

0 1 2 3 4 5

FCF from Table 2 760 731 731 702 643

PV of FCF at WACCAT = 8.5%, V 2,827 2,307 1,773 1,193 593

Market Value of Debt, WD 25% 25% 25% 25% 25%

Loan Proceeds/Outstanding Loan, Ln = WD x V 707 577 443 298 148

Principal Payment, (Pp)n = L(n-1) – Ln 130 134 145 150 148

Interest Payment, (Ip)n = L(n-1) x KD 43 35 27 18 9

Interest Tax Savings, (ITS)n = (Ip)n x Tc 15 12 10 6 3

The constant D/V ratio does not fit well with observed practice and/or may be difficult to

maintain. Firms more typically manage issue amounts and repayment schedules, and

would find it very difficult to maintain a constant debt ratio in a world of changing equity

values (see Vélez-Pareja and Tham 2005 and Tham and Vélez-Pareja, 2005.

Applicability of the Classic WACC Concept in Practice

If the constant D/V ratio assumption is violated, all three discount factors will give

different NPVs even if the right combination of cash flow and discount factor is used.

2. The corporate tax rate in Equations (1) and (2) is constant throughout the life of the

investment, i.e. no tax holidays or sliding scale taxes.

3. The term K D (1 − Tc ) in Equation (1) implies that the taxes are paid the same year as they

are accrued.

4. The term K D (1 − Tc ) in Equation (1) also implies that interest will be paid every year

throughout the life of the project.

5. Assumes that the tax shields are always realized in the year in which they occur. This

means that earnings before interest and taxes are greater than or equal to the expected

interest charges and that tax is paid the same year as accrued.

6. Those equations assume that the only source of tax shields is the interest payments.

7. Item 5 above also implies that there are no losses carried forward.

8. The capital cash flow must equal the sum of equity cash flow and cash flow to debt

holders, i.e., CCF = CFD + ECF as shown in Table 7.

9. The Interest tax savings must equal the capital cash flow minus the free cash flow, i.e.,

ITS = CCF – FCF as shown in Table 7.

Table 7. Match Between CCF, CFD and ECF (Proof of Assumptions 7 & 8)

0 1 2 3 4 5

Loan Proceeds 707

Principal Payments (130) (134) (145) (150) (148)

Interest Expenses (43) (35) (27) (18) (9)

Equals – CFD (707) 173 169 172 168 157

Plus – ECF (1,793) 602 574 568 540 489

Equals – CCF (2,500) 775 743 741 708 646

Matches CCF from Table 4 (2,500) 775 743 741 708 646

Less – FCF from Table 2 2,500 (760) (731) (731) (702) (643)

Equals – ITS 0 15 12 10 6 3

Matches ITS from Table 4 0 15 12 10 6 3

Textbook versus Real Investments

The above discussion dealt with textbook cases of the classic WACC concept. However, in

practice the execution of this concept becomes even more complicated and restricted. Over the

years, since inception of this concept, the textbooks and literature have conveniently avoided its

use and limitations in practice. Most conventional investment/ project evaluations may involve:

Applicability of the Classic WACC Concept in Practice

• Two to four years of construction period in which capital is spent and there is no

revenue.

• Interest accumulates on borrowed money during this construction period.

• Tax holidays and/or variable tax rates.

• Debt repayment schedule less than the total evaluation period of the project, i.e. the

debt-to-value ratio is not constant.

• Conventional debt repayment schedule based on book values rather than the market

values. When we set D%=D/V constant we have to CHANGE debt (up or down) based

on market value in order to maintain D/V constant. The other way around, if we do not

do that, then D/V is not constant.

Tables 8 to 10 show a classic (real life) project cash flows. Table 8 shows FCF of a 10-year

project with three years of construction period. Table 9 shows CCF of the data in Table 8 with

the addition of the interest tax savings. Table 10 shows ECF of the data in Table 8 with the

addition of a 5-year debt repayment schedule. Conventional, not based on market value of

project, debt repayment schedule is used to payback the debt in five years. Interest is applied to

the debt during the construction period.

Table 8. Free Cash Flow (FCF)

1 2 3 4 5 6 7 8 9 10 11 12 13

Gross Income 1,000.0 950.0 950.0 900.0 800.0 750.0 700.0 650.0 600.0 550.0

Less Cost of Goods Sold (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Operating Expenses (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Depreciation (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0)

Equal Taxable Income 547.0 502.0 502.0 457.0 367.0 322.0 277.0 232.0 187.0 142.0

Less Taxes @ 35% (191.5) (175.7) (175.7) (160.0) (128.5) (112.7) (97.0) (81.2) (65.5) (49.7)

Equal Income after tax - - - 355.6 326.3 326.3 297.1 238.6 209.3 180.1 150.8 121.6 92.3

Plus Depreciation 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0

Equal Free Cash Flow, FCFn (706.0) (1,412.0) (1,412.0) 708.6 679.3 679.3 650.1 591.6 562.3 533.1 503.8 474.6 445.3

Applicability of the Classic WACC Concept in Practice

1 2 3 4 5 6 7 8 9 10 11 12 13

Gross Income 1,000.0 950.0 950.0 900.0 800.0 750.0 700.0 650.0 600.0 550.0

Less Cost of Goods Sold (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Operating Expenses (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Depreciation (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0)

Equal Taxable Income 547.0 502.0 502.0 457.0 367.0 322.0 277.0 232.0 187.0 142.0

Less Taxes @ 35% (191.5) (175.7) (175.7) (160.0) (128.5) (112.7) (97.0) (81.2) (65.5) (49.7)

Less Income after tax - - - 375.5 342.7 339.0 305.7 243.0 209.3 180.1 150.8 121.6 92.3

Plus Depreciation 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0

Capital Cash Flow, CCFn (706.0) (1,412.0) (1,412.0) 728.5 695.7 692.0 658.7 596.0 562.3 533.1 503.8 474.6 445.3

1 2 3 4 5 6 7 8 9 10 11 12 13

Gross Income 1,000.0 950.0 950.0 900.0 800.0 750.0 700.0 650.0 600.0 550.0

Less Cost of Goods Sold (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Operating Expenses (50.0) (47.5) (47.5) (45.0) (40.0) (37.5) (35.0) (32.5) (30.0) (27.5)

Less Depreciation (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0) (353.0)

Equal Taxable Income 490.0 455.1 465.8 432.1 354.2 322.0 277.0 232.0 187.0 142.0

Less Taxes @ 35% (171.5) (159.3) (163.0) (151.3) (124.0) (112.7) (97.0) (81.2) (65.5) (49.7)

Equal Income after tax - - - 318.5 295.8 302.8 280.9 230.2 209.3 180.1 150.8 121.6 92.3

Plus Depreciation 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0 353.0

Equal Equity Cash Flow, ECFn (529.5) (1,059.0) (1,059.0) 507.6 474.9 471.1 437.9 375.2 562.3 533.1 503.8 474.6 445.3

The NPVs of the cash flows in Tables 8 to 10 are shown in Table 11. The difference in the

NPVs is worth noting. The NPV based on the WACCAT or WACCBT from (1) and (2) and KLE

from Table 1 is 156% more than the NPV of the ECF. This clearly shows that violating the

assumptions on which the methodology is based (i.e. market value of debt and the constant debt-

to-value ratio) could be catastrophic. The magnitude of the difference depends on the cash flow

pattern. In some cases the difference may not be as severe as shown in this example. Such a

difference can easily lead to selecting an investment that will show a positive NPV but the

investment will actually loose on equity.

Applicability of the Classic WACC Concept in Practice

% Different % Different

Type of Cash Flow NPV

from ECF from APV

Capital Cash Flow – CCF at WACCBT $ 101.2 82% 10%

Equity Cash Flow – ECF at KLE $ 55.6 0% -39.7%

Adjusted Present Value (APV) $ 92.5 0%

The example just presented is dramatic, but subtle versions of the same magnitude are

mundane. The source of difference is mainly due to failure to observe the interdependence of the

individual elements of the WACC with the cash flow itself and failure to meet the assumptions

as described below.

1. The WACCAT equation assumes constant Debt-to-Value ratio of 25%. However, as

shown in Figure 1, this ratio is higher than the 25% in the beginning and it is zero in the

later years of the project. This fact is not recognized by the WACCAT thus exaggerating

the NPV. The issue here is to assume that leverage (and WACC) is constant when it is

not.

2. Figure 2 shows that the actual interest payments have been over the years 2009 to 2013.

However, the WACCAT does not recognize this and keeps on accounting for tax savings

due to interest in the years 2006 to 2008 and then in the years 2014 to 2018.

3. Figure 3 shows that the cost of equity is not constant. However, the WACCAT is based on

the assumption that the cost of equity is 10% throughout the project life.

As shown above, the difference in the NPV from one method to the other is due to the

violation of the assumptions on which the WACC concept is based. These kinds of discrepancies

can be avoided if the relationship between the cash flow items and the discount factor are

ascertained.

Applicability of the Classic WACC Concept in Practice

Applicability of the Classic WACC Concept in Practice

Table 12 shows the use of four different methods, each acknowledging the cash flow

structure and corresponding discount rate, to arrive at the NPV. It is worth noting that all four

methods calculate identical NPV of $92.5. The methods used to arrive at the NPV’s in Table 12

are described in the following pages.

1. The PV(FCF) is calculated using Equation (3). The calculation of NPV in this way

involves iterative solution (circularity in MS Excel™). To solve circularity in MS

Excel™, go to Tools Options Calculations tick Iteration.

FCFt +1 + PV (FCF )t +1

PV (FCF )t = (3)

1 + WACCt +1

where1

ITS t

WACCt = K ULE −

PV (FCF )t −1

1

Taggart 1991, presented this expression for WACC and Vélez-Pareja and Tham (2000), Tham, and Velez–Pareja, 2002, Vélez-

Pareja and Burbano 2005 and Tham, Velez–Pareja, 2004a and 2004b, derived independently the expression when cash flows are

finite.

Table 12. Alternative Approaches to Calculating NPV

NPV 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Debt Cash Flow, CFD (177) (353) (353) 221 221 221 221 221 - - - - -

Equity Cash Flow, ECF (530) (1,059) (1,059) 508 475 471 438 375 562 533 504 475 445

Capital Cash Flow, CCF = CFD + ECF (706) (1,412) (1,412) 728 696 692 659 596 562 533 504 475 445

Free Cash Flow, FCF (706) (1,412) (1,412) 709 679 679 650 592 562 533 504 475 445

WACC = KULE - TS/PV(FCF) 9.10% 9.10% 9.10% 8.59% 8.64% 8.70% 8.79% 8.91% 9.10% 9.10% 9.10% 9.10% 9.10%

PV(FCF) 92.5 807 2,292 3,913 3,540 3,167 2,763 2,356 1,974 1,592 1,203 809 408 -

PV(ECF), V = ECF/KLE 92.5 630 1,752 2,986 2,778 2,578 2,359 2,148 1,974 1,592 1,203 809 408 -

Debt-to-Value Ratio, D/V 28.00% 30.84% 31.03% 27.46% 22.84% 17.13% 9.69% 0.00% 0.00% 0.00% 0.00% 0.00%

KLE = KULE + (KULE - KD) * W D 9.10% 9.93% 10.01% 10.02% 9.91% 9.77% 9.61% 9.39% 9.10% 9.10% 9.10% 9.10% 9.10%

Adjusted Present Value, APV 92.5 <== (NPV of FCF + NPV of ITS) @ KULE

Applicability of the Classic WACC Concept in Practice

2. The PV(ECF) is calculated using Equation (4). The calculation of NPV in this way

involves iterative solution (circularity in MS Excel™) by which the discount rate each

year is calculated based on the D/V during that year as shown below.

ECFt +1 + PV (ECF )t +1

PV (ECF )t = (4)

(1 + K LE )t

where

ITS t

WACCt = KULE −

PV ( FCF ) t −1

And

WDt −1

K LEt = K ULE +(K ULE − K D )

WEt −1

Dt −1

(WD )t −1 =

Dt −1 + PV (ECF )t −1

PV (ECF )t −1

(WE )t −1 =

Dt −1 + PV (ECF )t −1

Where

3. The capital cash flow (CCF) is discounted using the Unlevered cost of equity (KULE =

9.10% from Table 1).

4. The Adjusted Presented Value (APV) is the sum of the NPV of FCF at the Unlevered

cost of equity and the PV of the ITS at the Unlevered cost of equity. The formula for

WACC, KLE and WACC for CCF (equal to KULE) are correct UNDER the assumption

that the discount rate of the ITS is KULE.

Applicability of the Classic WACC Concept in Practice

Concluding Remarks

The above analyses prove that the only compelling virtue for advocating the use of the classic

WACC equation [as shown in Equation (1)] is that it requires simplified cash flow. This

property, of course, could have been important in the past to users of calculators, interest tables

and/or slide rule. However, due to the tremendous power of spreadsheets like MS Excel™, that

advantage is irrelevant today. Moreover, one has to make sure that the simplification is worth

compromising on the ultimate decision making.

Based on the above analyses, it is recommended to either use the ECF and the cost of equity

(KLE) combination to calculate the NPV’s or use the Adjusted Present value (APV). The ECF is

also the cash flow that, at the end of the day, will be used for budgeting and planning purposes.

The ECF methodology is a good way to obtain a lower bound for the value of the equity. The

NPV based on ECF may, at times, be slightly conservative. This is because the levered cost of

equity (derived from CAPM) is used throughout the project life. Since after the 5-year debt

repayment schedule the un-levered cost of equity will be somewhat less than the levered cost of

equity, the NPV may be slightly conservative. By using the Adjusted Present Value (APV)

method, the NPV for the same investment was calculated to be $92.5.

The bottom line in this issue is to recognize that when properly done, all methods have to

be identical in their results, as was shown in this paper. The wrong approaches give conservative

results in some cases, but the problem is that when the analyst gets different results from

different methods, she will not know which one is the correct one. As a guide, as suggested in

the previous paragraph, if ITS are calculated correctly, the reference point always will be the

APV or the present value of the CCF as the easiest forms to calculate value2.

Bibliographic References

1. Benninga, Simon Z. and Oded H. Sarig, 1997, Corporate Finance. A Valuation

Approach, McGraw-Hill.

2. Brealey, Richard and Stewart C. Myers, 2003, Principles of Corporate Finance, 7th

edition, McGraw Hill-Irwin, New York.

3. Brealey, Richard, Stewart C. Myers and Franklin Allen, 2006, Principles of Corporate

Finance, 8th edition, McGraw Hill-Irwin, New York.

4. Copeland, Thomas and Fred J. Weston, 1988, Financial Theory and Corporate Policy,

3rd Edition, Addison-Wesley.

5. Copeland, Thomas E., Koller, T. y Murrin, J., 2000, Valuation: Measuring and

Managing the Value of Companies, 3rd Edition, John Wiley & Sons, (July 28).

2

The reader has to realize that in the context of this paper we have assumed that ψ, the discount rate for the ITS is

Ku, the cost of unlevered equity.

Applicability of the Classic WACC Concept in Practice

6. Mohanty, Pitabas, 2003, "A Practical Approach to Solving the Circularity Problem in

Estimating the Cost of Capital". August 13, Social Science Research Network,

http://ssrn.com/abstract=413240

7. Myers. Stewart C, 1974, "Interactions of Corporate Financing and Investment Decisions:

Implications for Capital Budgeting", Journal of Finance, 29, March, pp 1-25.

8. Ross, Stephen A., Randolph W. Westerfield and Jeffrey Jaffe, 1999, Corporate Finance,

5th edition, Irwin-McGraw-Hill.

9. Ruback, Richard S., 1995, “A Note on Capital Cash Flow Valuation,” Harvard Business

School Case 9-295-069, January 19.

10. Taggart, Jr, Robert A., 1991, Consistent Valuation Cost of Capital Expressions with

Corporate and Personal Taxes, Financial Management, Autumn,. pp. 8-20.

11. Tham, Joseph and Vélez-Pareja , Ignacio, 2002, "An Embarrassment of Riches: Winning

Ways to Value with the WACC" (November). Social Science Research Network,

http://ssrn.com/abstract=352180

12. Tham, Joseph and Vélez-Pareja , Ignacio, 2004a, "For Finite Cash Flows, what is the

Correct Formula for the Return to Leveraged Equity?" (May 10), Social Science

Research Network, http://ssrn.com/abstract=545122

13. Tham, Joseph and Velez-Pareja, Ignacio, 2005, "Modeling Cash Flows with Constant

Leverage: A Note" (June 28). Available at Social Science Research Network:

http://ssrn.com/abstract=754444

14. Tham, Joseph and Ignacio Vélez-Pareja, 2002, Modeling the Impacts of Inflation in

Investment Appraisal, Working Paper. Available through the Social Science Research

Network (SSRN).

15. Tham, Joseph and Vélez-Pareja, Ignacio, 2004b, Principles of Cash Flow Valuation.

An Integrated Market Approach, Academic Press.

16. Tham, Joseph and Ignacio Vélez-Pareja, 2004c, “Top 9 (Unnecessary and Avoidable)

Mistakes in Cash Flow Valuation,” Working Paper en SSRN, Social Science Research

Network, Jan,

17. Velez-Pareja, Ignacio and Antonio Burbano, 2005, Consistency in Valuation: A Practical

Guide, Social Science Research Network, July 13-15,

18. Velez-Pareja, Ignacio and Tham, Joseph, 2000, "A Note on the Weighted Average Cost

of Capital WACC" (August 7,). Available at Social Science Research Network:

http://ssrn.com/abstract=254587 or DOI: 10.2139/ssrn.254587

19. Velez-Pareja, Ignacio and Tham, Joseph, 2006, "Valuation of Cash Flows with Constant

Leverage: Further Insights" (May 20). Available at Social Science Research Network:

http://ssrn.com/abstract=879505

20. Velez-Pareja, Ignacio and Tham, Joseph, 2005, "Proper Solution of Circularity in the

Interactions of Corporate Financing and Investment Decisions: A Reply to the Financing

Present Value Approach" (January 22,). Management Research News, Vol. 28, No. 10,

Applicability of the Classic WACC Concept in Practice

http://ssrn.com/abstract=653222

21. Velez-Pareja, Ignacio and Tham, Joseph, 2006, "The Mismatching of APV and the DCF

in Brealey, Myers and Allen 8th Edition of Principles of Corporate Finance, 2006"

(September 19). Available at Social Science Research Network:

http://ssrn.com/abstract=931805

22. Wood, J Stuart and Gordon Leitch, 2004, Interactions of corporate financing and

investment decisions: the financing present value ("FPV") approach to evaluating

investment projects that change capital structure, Managerial Finance, 1 February 2004,

vol. 30, no. 2, pp. 16-37(22).

- End SheetsUploaded byFawad Sarwar
- Valuation ReportUploaded byhiteksha
- Assignment 03Uploaded byRauan Zhakypbek
- Exploration Economics 2004Uploaded byGeorge Georgiadis
- 2Uploaded bylyjucochin
- Cost of CapitalUploaded byKaran Jaiswal
- DCF Template S2018Uploaded byEthan
- FINANCIAL MANAGEMENT ( MBA )Uploaded byAjesh Mukundan P
- Project managementUploaded byGaurav Sharma
- Twou Short IdeaUploaded byAnonymous Ht0MIJ
- CCOLA0109Uploaded byumuttk5374
- Managing Finincial Principles & Techniques Ms.safinaUploaded byjojiraja
- Evaluating FlexibilityUploaded byHannan Afifi
- 284595216-Natureview-Farm-Case-Analysis.xlsxUploaded bykks4h
- Fin 600_Radio One-Team 3_ Final SlidesUploaded byNavinMohan
- DONE - Reference- Esaa16_publicUploaded bysudhanshu006
- 10 DCA 2Uploaded byeduson2013
- Nice Looking ReportUploaded byDallas Dragon
- Q4Uploaded byanon_236934580
- 12221-14573-1-PBUploaded bynadya ratnasari
- 12221-14573-1-PB.pdfUploaded bynadya ratnasari
- Final Note SheetUploaded byMilind Shirolkar
- Ebit Eps AnalysisUploaded byPiyuksha Pargal
- Lease_versus_Buy_example.docUploaded byTedi Ridola
- ANNUAL-REPORT-2017-18.pdfUploaded bySACHIN GEORGE 1827726
- Investment Opportunity.pptxUploaded bywestere
- PM Assignment 1Uploaded bySuraj Sriram
- Appendix-B [Answers to End-Of-Chapter Problems]Uploaded bySourov
- COST OF CAPITAL_03Uploaded byAshish Dhawan
- Chapter 5 OutlineUploaded byJoseff Anthony Fernandez

- Five Factor Asset Pricing ModelUploaded bymathfreak123
- Does It Pay Off the NPV of Advertising Pension FundsUploaded byShito Ryu
- Increasing Shareholders Value Through NPV-Negative ProjectsUploaded byShito Ryu
- Average Internal Rate of Return and Investment Decisions A New Perspective.pdfUploaded byShito Ryu
- Fighting Uncertainty with Uncertainty Time Value of Knowledge and the Net Present Value (NPV) of Knowledge Machines.pdfUploaded byShito Ryu
- Equivalence of the Apv, Wacc and Flows to Equity Approaches to Firm ValuationUploaded byShito Ryu
- Construction of Cash Flows RevisitedUploaded byShito Ryu
- Cost of Capital Estimation and Capital Budgeting Practice in AustraliaUploaded byShito Ryu
- Correct or Incorrect Application of CAPM Correct or Incorrect Decisions With CAPM.pdfUploaded byShito Ryu
- A Resolution to the NPV - IRR DebateUploaded byShito Ryu
- Are Capital Expenditures, R&D, Advertisements and Acquisitions Positive NPVUploaded byShito Ryu
- Capital Budgeting NPV v. IRR Controversy, Unmasking Common AssertionsUploaded byShito Ryu
- Capital Budgeting - Decision Making Practices in PakistanUploaded byafridi65
- Average Costs Versus Net Present ValueUploaded byShito Ryu
- Another Dark Side of IRR - Excessive Leverage, Increased Default Risk and Wealth DestructionUploaded byShito Ryu
- A Quasi-IRR for a Project Without IRRUploaded byShito Ryu
- A New Method to Estimate NPV and IRR From the Capital Amortization Schedule and an Insight Into Why NPV is Not the Appropriate Criterion for Capital Investment DecisionUploaded byShito Ryu
- A Monte Carlo Comparison Between the Free Cash Flow and Discounted Cash Flow ApproachesUploaded byShito Ryu
- A Tale of Two Cities - Charles DickensUploaded byJ T
- Size, Value, And Momentum in Emerging Market Stock Returns Integrated or Segmented PricingUploaded byShito Ryu
- Size, Value, And Momentum in Emerging Market Stock Returns Integrated or SegmentedUploaded byShito Ryu
- The Role of Analysts' Forecasts in the Momentum EffectUploaded byBhuwan
- Size, Value, And Momentum in International Stock ReturnsUploaded byShito Ryu
- Counter SpeculationUploaded byShito Ryu
- Corporate Ownership Around the WorldUploaded byShito Ryu
- CEO Overconfidence and Corporate InvestmentUploaded byShito Ryu
- A Crisis of Banks as Liquidity ProvidersUploaded byShito Ryu
- modern portfolioUploaded byShito Ryu
- Titman_wessel_-_determinants_of_cs_1988.pdfUploaded byIchsan Feriansyah

- IFRS Accounting Guidance September 2003Uploaded byMariana Mirela
- Hrm301 ReportUploaded byMahmuda Sharmeen Rahman Misha
- CF Chapter 11 Excel Master StudentUploaded byjulita08
- methodology-sp-us-indices.pdfUploaded byShamshadAli
- nov03news_spauldingUploaded byyc2
- Brian Spector Leaving Baupost Letter - Business InsiderUploaded byHedge Fund Conversations
- Ratio AnalysisUploaded bysubirdas143
- PitchbookUploaded byAnonymous DTIFVd
- BNHN-FTI Monthly Restaurant Review 2006.1Uploaded bybjktoy2342
- case3Uploaded bycalvin
- Remuneration and reward strategies for law firmsUploaded byArk Group
- Equity Markets in IndiaUploaded bySULAV SHEE
- Currency FluctuationUploaded bySaira Rashid
- Chap003 RevisedUploaded byAnith Kumar
- Leverage - Operating & FInancialUploaded byAmit
- Peakside CapitalUploaded byPierre Francois
- Project Sindu'Uploaded byDanish D Kovilakath
- TSLA Stock Quote - Tesla Motors IncUploaded byBaikani
- Redstar Gold Corp.pdfUploaded bykaiselk
- Indian Hotel JPMUploaded byViet Vu
- ECE_Chap 5_Funding for Start-upsUploaded byChourouk Haisni
- Analysis of Demat Account and Online TradingUploaded bykamdica
- Accounting I Crib SheetUploaded byschinni
- The Influence of the Dividend Payout Ratio (Dpr) and the Current Ratio (Cr) Against the Growth of Share Prices in the Service Sector Companies the Period 2011 – 215, in IndonesiaUploaded byInternational Journal of Innovative Science and Research Technology
- CompanyUploaded byNidha Mohammed
- Valuation-of-Goodwill.pdfUploaded byc_bhanushali555
- Research Note - Investing in DrawdownsUploaded bybasnagtzaam
- AppendixeuQ42007Uploaded byNeha Agarwal
- Investments 7E by Bodie Kane Marcus Ch1 TB SAMPLEUploaded bytestingscrib
- Chapter 22 - Dividend PolicyUploaded bySangeetha NarayanaSamy