17 10 Weighted Average Cost of Capital WACC
Weighted Average Cost of Capital (WACC)
Presentation Objectives • • • • • • • •
Define WACC Explain source of each component of the formula WACC Model – available to participants Strengths of WACC Weaknesses of WACC Controlling interest vs Minority interests Courts criticism of WACC Q&A
Weighted Average Cost of Capital (WACC) is the cost of capital (discount rate) determined by the weighted average, at market value, of the cost of all financing sources in the business enterprise’s capital structure.
International Glossary of Business Valuation Terms adopted by American Institute of Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Business Valuators, National Association of Certified Valuators and Analysts, and The Institute of Business Appraisers
The formula for WACC is as follows:
WACC = (ke x We) + (kd/(pt) [1-t] x Wd) Ke We
= =
Kd/(pt) = t = Wd
=
cost of common equity capital percentage of common equity in the capital structure, at market value cost of debt capital (pre-tax) effective income tax rate for the company percentage of debt in the capital structure, at market value
Cost of Common Equity Capital (Ke) • Duff & Phelps Risk Premium Study – use tab labeled “Summary – Unlevered COE” COE subject company = Rf + RP m+s, unlevered + ERP Adjustment – Rf – risk free rate – RP m+s, unlevered – risk premium market plus size on an unlevered basis • RPm+s, unlevered = RPm+s, levered – ((Wd / We) x (βu-βd) x RPm)
– RPm+s, unlevered = Unlevered realized risk premium over the risk-free rate » RPm+s, levered = Levered realized risk premium over the risk-free rate » βu = Unlevered equity beta » βd = Debt beta, assumed equal to 0.1 » RPm = Equity risk premium (ERP) estimate for the “market”, represented by the average historical risk premium since 1963 » Wd = Percent of debt capital in capital structure » We = Percent of equity capital in capital structure » ERP Adjustment –The ERP Adjustment is a necessary adjustment that represents the difference between the historical equity risk premium (ERP) used as a convention to calculate the various risk premia and size premia in the Report, and a user of the Report’s own forward ERP estimate. The ERP Adjustment is always necessary when using “risk premia over the risk-free rate”, but is never necessary when using “risk premia over CAPM” (i.e., size premia).
Cost of Common Equity Capital (Ke) continued • Build-up Method – CRSP (Center for Research in Security Prices) data in Valuation Handbook – U.S. Guide to Cost of Capital’s – The CRSP Deciles Size Premia do not include unlevered premia. – If you use the build-up method, you will need to unlever the cost of equity capital.
• Other Sources – If you are using other sources to determine cost of equity, such as; Dr. Aswath Damodaran, Implied Private Company Pricing Line, CAPM, other, you will need to unlever the cost of equity capital if the cost of equity capital is levered.
Percentage of Common Equity in the Capital Structure, at Market Value (We) • Since no market exists for private companies, assigning weights at market value of the capital structure components requires one of the following sources or methodologies: – An iterative process • Starting with the initial capital structure of the subject company and repeating the process until a reasonable WACC and accompany capital structure is achieved. • Electronic spreadsheets make the iterative process easier, see model provided in this presentation. • Preferred method – tailored to the subject company
– Proxy capital structures from public company data – Proxy capital structures from private company industry data.
Cost of Debt Capital (pre-tax) (Kd/(pt)) The cost of debt capital (pre-tax) should be a forward looking (“all-in”) rate based on the level of debt capital the subject company can obtain and repay within the required terms, see “percent of debt in capital structure” for more guidance
Cost of Debt Capital (pre-tax) (Kd/(pt)) continued • Sources for cost of debt capital (pre-tax) are as follows: – Pepperdine Private Capital Markets Report (PPCMR) • Table 15 – All-in rates by loan size and industry • Table 16 – All-in rates by loan type • Rates from table 15 and 16 are based on average expected future rates. – Analyst may need to adjust the average expected future rate for the credit worthiness of the subject company.
Cost of Debt Capital (pre-tax) (Kd/(pt)) continued • Sources for cost of debt capital (pre-tax) are as follows (continued): – Thomson Reuters LPC for domestic rates • • • •
Gold Sheets Gold Sheets Middle Market Thomson Reuters LPC Annual Gold Sheets Daily
– Thomson Reuters LPC for non-domestic rates • For Asia/Pacific rates see Asia/Pacific-Basis Point and Asia/Pacific-Basis Point Annual. For Europe rates see EMEA-European Loan Market Pulse and EMEA-European Secondary Market Pulse
Cost of Debt Capital (pre-tax) (Kd/(pt)) continued • Sources for cost of debt capital (pre-tax) are as follows (continued): – Lenders in subject company’s market area • Caution – this source (hearsay) may not be defensible in litigation engagements.
– Subject Company’s existing debt rate • Caution – this source will result in the wrong cost of debt capital if the subject company is inability to maintain the existing debt, the company has the ability to obtain more favorable rates due to improved financial performance, or the existing debt pricing is based on strength of shareholder guarantee. During the recession, analysts found existing debt agreements that were unsustainable and, in many cases, the lender was not renewing the existing debt, increasing rates and/or requiring additional equity capital infusion. It is important to use a forward looking rate based on the future cash flows and future financial condition of the subject company.
Effective Income Tax Rate for the Company (t) • Use the effective income tax rate for the subject company to convert cost of debt capital (pre-tax) to an after-tax cost of debt capital. – C Corporations • Effective income tax rate on future cash flows
– Pass-through Entities (PTE) • Analyst should use the same effective income tax rate used to determine future cash flows.
Percentage of Debt in the Capital Structure, at Market Value (Wd)
Use the market value of debt to determine the percentage of debt in the capital structure.
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued • When valuing a control interest, determine the market value of debt from the following sources or methodologies: – Optimum capital structure • Assuming the buyer will optimize the capital structure, the optimum level of debt capital will generally be determined based on the subject company’s ability to obtain and repaid the debt capital. The level of debt capital could be determined using the following ratios: – Standard advance rates » See SBA guidelines or PPCMR table 26 for guidelines – Collateral ratio » See SBA guidelines or PPCMR table 21 – Senior leverage multiple (e.g. PPCMR table 17) – Fixed charge coverage ratio or debt service coverage ratio (e.g. PPCMR table 20)
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued • Other sources to use when determining the market value of debt : – Industry capital structure • Ibbotson Cost of Capital, or • Private company industry profiles
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued • Analyst may differ on the market value of debt when valuing a minority interest. When valuing a minority interest it is often appropriate to use the actual debt structure of the subject company based on the premise that the minority interest cannot change the existing capital structure. The problem with using the existing debt structure is as follows: – Overstatement or understatement of WACC – Mismatch between future cash flows and existing debt structure when the subject company is unable to sustain actual debt structure going forward. – Indication of value may be overstated or understated because capital structure is not optimized; therefore, not representative of the enterprise value.
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued The analyst should evaluate the investment horizon of the subject interest and the most likely exit strategy when determining the market value of debt. If the minority interest is expected to be purchased as part of a sale of the company, it may be appropriate to use an optimum capital structure, which would be more representative of the buyer’s capital structure.
WACC Model Weighted average cost of capital Market Value Debt $ 1,000,000 Equity 4,016,180 TIC $ 5,016,180 LT sustainable growth rate Capitalization rate for next year Convert to current year Capitalization rate for current year
Weight 19.94% 80.06%
Cost Tax 8.00% 25.30% 23.64%
1.19% 18.93% 20.12% -3.42% 16.70% 103.42% 16.15%
WACC Model (continued) Normalized future EBITDA Less future depreciation and amortization Less future interest expense Less income taxes Estimated future earnings Add: non-cash charges - depreciation and amortization Add: interest expense (net of tax) Less: capital expenditures necessary to support projected operations Estimated annual working capital restoration
$
1,301,000 (150,000) (80,000) (271,000) 800,000 150,000 59,760 (150,000) (50,000)
Estimated future cash flows to total invested capital (rounded) Weighted average cost of capital capitalization rate
$
810,000 16.15%
Total invested capital (rounded)
$
5,016,180
WACC Model (continued) Total invested capital (rounded) Operating debt Current portion of long-term debt Long-term debt Total operating debt (rounded) Indication of equity value of operating entity
$
500,000 1,500,000 2,000,000 3,016,180
Non-operating assets Marketable controlling interest value
5,016,180
750,500 $
3,766,680
Weighted average cost of capital Market Value Debt $ 1,000,000 Equity 4,016,180 TIC $ 5,016,180
Weight 19.94% 80.06%
Cost Tax 8.00% 25.30% 23.64%
LT sustainable growth rate Capitalization rate for next year Convert to current year Capitalization rate for current year
1.19% 18.93% 20.12% -3.42% 16.70% 103.42% 16.15%
Normalized future EBITDA Less future depreciation and amortization Less future interest expense Less income taxes Estimated future earnings Add: non-cash charges - depreciation and amortization Add: interest expense (net of tax) Less: capital expenditures necessary to support projected operations Estimated annual working capital restoration
$
1,301,000 (150,000) (80,000) (271,000) 800,000 150,000 59,760 (150,000) (50,000)
Estimated future cash flows to total invested capital (rounded) Weighted average cost of capital capitalization rate
$
810,000 16.15%
Total invested capital (rounded) Operating debt Current portion of long-term debt Long-term debt Total operating debt (rounded) Indication of equity value of operating entity
$
500,000 1,500,000 2,000,000 3,016,180
Non-operating assets Marketable controlling interest value
5,016,180
750,500 $
3,766,680
WACC Model - instructions • Cell L7 (located outside the model above) is =+C10I30. This formula should equal 0 – 2. • Step one – Select “Data” from menu bar • Step two – Select “What-If Analysis” from menu bar • Step three – Select “Goal Seek” from pop down menu • Step four – Enter L7 as “set cell” • Step five – Enter “0” as “To value” • Step six – Enter C9 as “by Changing” • Step seven – Select “OK” • Step eight – After Cell C10 and C30 are the same (+/2), press “OK” again
Strengths of WACC • Most common methodology for determining cost of capital for transactional purposes. – Generally the buyer’s WACC since most sellers will retire their existing debt as a condition of the sale process. – WACC “is by far the most widely used discount rate for valuing the business enterprise, it is based on certain simplifying assumptions that may or may not be true in specific circumstances.” Valuation Handbook, 2017, U.S. Guide to Cost of Capital, published by Duff & Phelps and Wiley.
Strengths of WACC (continued) • Useful method of calculating cost of capital when existing debt of subject company is different than industry capital structure – Companies with no debt – Over-leveraged companies • Caution – the future cash flows of the company may not reflect the existing capital structure of an over-leveraged company. Analyst must be careful to properly match the capital structure with the future cash flows.
– Companies with multiple sources of capital • • • • • • •
Subordinated debt Mezzanine capital Bonds Debentures Preferred stock Warrants Etc.
Strengths of WACC (continued) • Useful with stable/constant or optimum capital structures • Hypothetical Buyer’s Perspective • Useful in evaluation of capital projects
Weakness of WACC • Use of WACC with changing capital structures over time will probably result in the incorrect value of the company or project. • Frequently misunderstood or applied improperly. • Courts may determine that WACC is inappropriate for valuing privately held companies. – Further discussion on the case law pertaining to WACC is provided in this presentation.
• Perceived to be complicated and/or time-consuming to use. – Neither of these perceptions are a valid reason for ignoring WACC when appropriate to use.
Court Cases • Furman v. Commissioner, T.C. Memo 1998157.1998 Tax Cr. Memo LEXIS 158, April 30, 1998 – Taxable gifts and taxable estate – Fair market value of shares in Furman’s Inc. (FIC) • Was the shares of common stock exchanged for preferred stock of FIC $300,000 as petitioners content or $540,540 as respondent contends? • Was the fair market value of the shares of FIC transferred to Robert G Furman in 1980 was $62,016 or $147,600 as respondent contends? BVLaw, Business Valuation Resources
Court Cases (continued) • Furman v. Commissioner (continued) – part of Judge Beghe’s opinion “We do not believe that CAPM and WACC are the proper analytical tools to value a small, closely held corporation with little possibility of going public.”
Court Cases (continued) • Furman v. Commissioner (continued) “To compute WACC, it is necessary to know the market value of the firm’s debt and equity, which if known, would go far toward negating the need to perform a valuation.”; Brealey & Myers, Principals of Corporate Finance 525 (7th ed. 2003). • Expert testimony should have been rendered regarding the simplicity of determining the market value of the firm’s debt and equity. Use of electronic tools makes this process easy to determine.
Court Cases (continued) • Estate of Gallagher v. Commissioner, T.C. Memo. 2011-148, 2011 WL 2559847 (US Tax Court), June 28, 2011, Judge Halpern – The decedent owned 15% in a family-founded newspaper publishing company, which also owned a television station and a few special media providers. In 1996, the company converted to a subchapter S corporation, and just before the valuation date (July 5, 2004), it acquired a 100% interest in another small publishing company. In connection with this and other planned acquisitions, the company refinanced a $400 million debt, for which it prepared certain financial forecasts. Finally, as of July 2004, the company had nearly 3,000 executive stock options outstanding, at an average price of roughly $2,800 per option.
• The decedent’s federal estate tax return valued her 15% share at $34.9 million, based on an appraisal conducted by the company’s president and CEO. In 2007, the IRS asserted the fair market value of the decedent’s units was $49.5 million. The taxpayer petitioned the Tax Court for a redetermination based on a new appraisal of $26.6 million. Before trial, both sides enlisted new appraisers and closed the gap slightly: $28.2 million for the taxpayer versus $40.86 million for IRS BVLaw, Business Valuation Resources
Court Cases (continued) • Estate of Gallagher v. Commissioner, included in Judge Halpern’s opinion “We agree that WACC is an improper discount rate tool for a company planning to pay down its debt, thereby changing its capital structure.” See Brealey & Myers, supra at 536. “However, given the parties’ reliance on their own experts, both of whom use the WACC formula in their respective analyses, we must adopt the approach. Therefore, we will use Mr. Thomson’s constant WACC rate in this case, although we do not intend to establish a general rule in doing so.”
Court Cases (continued) • Estate of Hendrickson v. Commissioner, T.C. Memo. 1999-278, 1999 Tax Ct. Memo LEXIS 318, August 23, 1999, Judge Beghe • The issue in this estate tax case was the fair market value of decedent’s 1,499 shares of Peoples Trust and Savings Bank of Boonville, Ind., constituting 49.97% of the 3,000 shares outstanding. Decedent’s estate filed a timely Estate Tax Return Form 706, stating the value of 1,486 of the shares to be $2,126 per share. BVLaw, Business Valuation Resources
Court Cases (continued) • Estate of Hendrickson v. Commissioner – Judge Beghe in his opinion stated “CAPM is a financial model intended to explain the behavior of publicly traded securities”, and we “do not believe that CAPM and WACC are the proper analytical tools to value a small, closely held corporation with little possibility of going public.” Furman v. Commissioner, T.C. Memo. 1998-157, 75 T.C.M. (CCH) 2206, 2214, 1998 T.C.M. (RIA) par. 98-157, at 868-98.
Summary • WACC methodology • Useful when capital structure of the Subject Company is different than the industry • Iteration required to calculate market value of Debt and Equity Capital using WACC • Analyst will need to explain to the tax court and other courts why WACC is applicable methodology
Questions and Answers
Presentation Objectives • • • • • • • •
Define WACC Explain source of each component of the formula WACC Model – available to participants Strengths of WACC Weaknesses of WACC Controlling interest vs Minority interests Courts criticism of WACC Q&A
Weighted Average Cost of Capital (WACC) is the cost of capital (discount rate) determined by the weighted average, at market value, of the cost of all financing sources in the business enterprise’s capital structure.
International Glossary of Business Valuation Terms adopted by American Institute of Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Business Valuators, National Association of Certified Valuators and Analysts, and The Institute of Business Appraisers
The formula for WACC is as follows:
WACC = (ke x We) + (kd/(pt) [1-t] x Wd) Ke We
= =
Kd/(pt) = t = Wd
=
cost of common equity capital percentage of common equity in the capital structure, at market value cost of debt capital (pre-tax) effective income tax rate for the company percentage of debt in the capital structure, at market value
Cost of Common Equity Capital (Ke) • Duff & Phelps Risk Premium Study – use tab labeled “Summary – Unlevered COE” COE subject company = Rf + RP m+s, unlevered + ERP Adjustment – Rf – risk free rate – RP m+s, unlevered – risk premium market plus size on an unlevered basis • RPm+s, unlevered = RPm+s, levered – ((Wd / We) x (βu-βd) x RPm)
– RPm+s, unlevered = Unlevered realized risk premium over the risk-free rate » RPm+s, levered = Levered realized risk premium over the risk-free rate » βu = Unlevered equity beta » βd = Debt beta, assumed equal to 0.1 » RPm = Equity risk premium (ERP) estimate for the “market”, represented by the average historical risk premium since 1963 » Wd = Percent of debt capital in capital structure » We = Percent of equity capital in capital structure » ERP Adjustment –The ERP Adjustment is a necessary adjustment that represents the difference between the historical equity risk premium (ERP) used as a convention to calculate the various risk premia and size premia in the Report, and a user of the Report’s own forward ERP estimate. The ERP Adjustment is always necessary when using “risk premia over the risk-free rate”, but is never necessary when using “risk premia over CAPM” (i.e., size premia).
Cost of Common Equity Capital (Ke) continued • Build-up Method – CRSP (Center for Research in Security Prices) data in Valuation Handbook – U.S. Guide to Cost of Capital’s – The CRSP Deciles Size Premia do not include unlevered premia. – If you use the build-up method, you will need to unlever the cost of equity capital.
• Other Sources – If you are using other sources to determine cost of equity, such as; Dr. Aswath Damodaran, Implied Private Company Pricing Line, CAPM, other, you will need to unlever the cost of equity capital if the cost of equity capital is levered.
Percentage of Common Equity in the Capital Structure, at Market Value (We) • Since no market exists for private companies, assigning weights at market value of the capital structure components requires one of the following sources or methodologies: – An iterative process • Starting with the initial capital structure of the subject company and repeating the process until a reasonable WACC and accompany capital structure is achieved. • Electronic spreadsheets make the iterative process easier, see model provided in this presentation. • Preferred method – tailored to the subject company
– Proxy capital structures from public company data – Proxy capital structures from private company industry data.
Cost of Debt Capital (pre-tax) (Kd/(pt)) The cost of debt capital (pre-tax) should be a forward looking (“all-in”) rate based on the level of debt capital the subject company can obtain and repay within the required terms, see “percent of debt in capital structure” for more guidance
Cost of Debt Capital (pre-tax) (Kd/(pt)) continued • Sources for cost of debt capital (pre-tax) are as follows: – Pepperdine Private Capital Markets Report (PPCMR) • Table 15 – All-in rates by loan size and industry • Table 16 – All-in rates by loan type • Rates from table 15 and 16 are based on average expected future rates. – Analyst may need to adjust the average expected future rate for the credit worthiness of the subject company.
Cost of Debt Capital (pre-tax) (Kd/(pt)) continued • Sources for cost of debt capital (pre-tax) are as follows (continued): – Thomson Reuters LPC for domestic rates • • • •
Gold Sheets Gold Sheets Middle Market Thomson Reuters LPC Annual Gold Sheets Daily
– Thomson Reuters LPC for non-domestic rates • For Asia/Pacific rates see Asia/Pacific-Basis Point and Asia/Pacific-Basis Point Annual. For Europe rates see EMEA-European Loan Market Pulse and EMEA-European Secondary Market Pulse
Cost of Debt Capital (pre-tax) (Kd/(pt)) continued • Sources for cost of debt capital (pre-tax) are as follows (continued): – Lenders in subject company’s market area • Caution – this source (hearsay) may not be defensible in litigation engagements.
– Subject Company’s existing debt rate • Caution – this source will result in the wrong cost of debt capital if the subject company is inability to maintain the existing debt, the company has the ability to obtain more favorable rates due to improved financial performance, or the existing debt pricing is based on strength of shareholder guarantee. During the recession, analysts found existing debt agreements that were unsustainable and, in many cases, the lender was not renewing the existing debt, increasing rates and/or requiring additional equity capital infusion. It is important to use a forward looking rate based on the future cash flows and future financial condition of the subject company.
Effective Income Tax Rate for the Company (t) • Use the effective income tax rate for the subject company to convert cost of debt capital (pre-tax) to an after-tax cost of debt capital. – C Corporations • Effective income tax rate on future cash flows
– Pass-through Entities (PTE) • Analyst should use the same effective income tax rate used to determine future cash flows.
Percentage of Debt in the Capital Structure, at Market Value (Wd)
Use the market value of debt to determine the percentage of debt in the capital structure.
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued • When valuing a control interest, determine the market value of debt from the following sources or methodologies: – Optimum capital structure • Assuming the buyer will optimize the capital structure, the optimum level of debt capital will generally be determined based on the subject company’s ability to obtain and repaid the debt capital. The level of debt capital could be determined using the following ratios: – Standard advance rates » See SBA guidelines or PPCMR table 26 for guidelines – Collateral ratio » See SBA guidelines or PPCMR table 21 – Senior leverage multiple (e.g. PPCMR table 17) – Fixed charge coverage ratio or debt service coverage ratio (e.g. PPCMR table 20)
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued • Other sources to use when determining the market value of debt : – Industry capital structure • Ibbotson Cost of Capital, or • Private company industry profiles
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued • Analyst may differ on the market value of debt when valuing a minority interest. When valuing a minority interest it is often appropriate to use the actual debt structure of the subject company based on the premise that the minority interest cannot change the existing capital structure. The problem with using the existing debt structure is as follows: – Overstatement or understatement of WACC – Mismatch between future cash flows and existing debt structure when the subject company is unable to sustain actual debt structure going forward. – Indication of value may be overstated or understated because capital structure is not optimized; therefore, not representative of the enterprise value.
Percentage of Debt in the Capital Structure, at Market Value (Wd) - continued The analyst should evaluate the investment horizon of the subject interest and the most likely exit strategy when determining the market value of debt. If the minority interest is expected to be purchased as part of a sale of the company, it may be appropriate to use an optimum capital structure, which would be more representative of the buyer’s capital structure.
WACC Model Weighted average cost of capital Market Value Debt $ 1,000,000 Equity 4,016,180 TIC $ 5,016,180 LT sustainable growth rate Capitalization rate for next year Convert to current year Capitalization rate for current year
Weight 19.94% 80.06%
Cost Tax 8.00% 25.30% 23.64%
1.19% 18.93% 20.12% -3.42% 16.70% 103.42% 16.15%
WACC Model (continued) Normalized future EBITDA Less future depreciation and amortization Less future interest expense Less income taxes Estimated future earnings Add: non-cash charges - depreciation and amortization Add: interest expense (net of tax) Less: capital expenditures necessary to support projected operations Estimated annual working capital restoration
$
1,301,000 (150,000) (80,000) (271,000) 800,000 150,000 59,760 (150,000) (50,000)
Estimated future cash flows to total invested capital (rounded) Weighted average cost of capital capitalization rate
$
810,000 16.15%
Total invested capital (rounded)
$
5,016,180
WACC Model (continued) Total invested capital (rounded) Operating debt Current portion of long-term debt Long-term debt Total operating debt (rounded) Indication of equity value of operating entity
$
500,000 1,500,000 2,000,000 3,016,180
Non-operating assets Marketable controlling interest value
5,016,180
750,500 $
3,766,680
Weighted average cost of capital Market Value Debt $ 1,000,000 Equity 4,016,180 TIC $ 5,016,180
Weight 19.94% 80.06%
Cost Tax 8.00% 25.30% 23.64%
LT sustainable growth rate Capitalization rate for next year Convert to current year Capitalization rate for current year
1.19% 18.93% 20.12% -3.42% 16.70% 103.42% 16.15%
Normalized future EBITDA Less future depreciation and amortization Less future interest expense Less income taxes Estimated future earnings Add: non-cash charges - depreciation and amortization Add: interest expense (net of tax) Less: capital expenditures necessary to support projected operations Estimated annual working capital restoration
$
1,301,000 (150,000) (80,000) (271,000) 800,000 150,000 59,760 (150,000) (50,000)
Estimated future cash flows to total invested capital (rounded) Weighted average cost of capital capitalization rate
$
810,000 16.15%
Total invested capital (rounded) Operating debt Current portion of long-term debt Long-term debt Total operating debt (rounded) Indication of equity value of operating entity
$
500,000 1,500,000 2,000,000 3,016,180
Non-operating assets Marketable controlling interest value
5,016,180
750,500 $
3,766,680
WACC Model - instructions • Cell L7 (located outside the model above) is =+C10I30. This formula should equal 0 – 2. • Step one – Select “Data” from menu bar • Step two – Select “What-If Analysis” from menu bar • Step three – Select “Goal Seek” from pop down menu • Step four – Enter L7 as “set cell” • Step five – Enter “0” as “To value” • Step six – Enter C9 as “by Changing” • Step seven – Select “OK” • Step eight – After Cell C10 and C30 are the same (+/2), press “OK” again
Strengths of WACC • Most common methodology for determining cost of capital for transactional purposes. – Generally the buyer’s WACC since most sellers will retire their existing debt as a condition of the sale process. – WACC “is by far the most widely used discount rate for valuing the business enterprise, it is based on certain simplifying assumptions that may or may not be true in specific circumstances.” Valuation Handbook, 2017, U.S. Guide to Cost of Capital, published by Duff & Phelps and Wiley.
Strengths of WACC (continued) • Useful method of calculating cost of capital when existing debt of subject company is different than industry capital structure – Companies with no debt – Over-leveraged companies • Caution – the future cash flows of the company may not reflect the existing capital structure of an over-leveraged company. Analyst must be careful to properly match the capital structure with the future cash flows.
– Companies with multiple sources of capital • • • • • • •
Subordinated debt Mezzanine capital Bonds Debentures Preferred stock Warrants Etc.
Strengths of WACC (continued) • Useful with stable/constant or optimum capital structures • Hypothetical Buyer’s Perspective • Useful in evaluation of capital projects
Weakness of WACC • Use of WACC with changing capital structures over time will probably result in the incorrect value of the company or project. • Frequently misunderstood or applied improperly. • Courts may determine that WACC is inappropriate for valuing privately held companies. – Further discussion on the case law pertaining to WACC is provided in this presentation.
• Perceived to be complicated and/or time-consuming to use. – Neither of these perceptions are a valid reason for ignoring WACC when appropriate to use.
Court Cases • Furman v. Commissioner, T.C. Memo 1998157.1998 Tax Cr. Memo LEXIS 158, April 30, 1998 – Taxable gifts and taxable estate – Fair market value of shares in Furman’s Inc. (FIC) • Was the shares of common stock exchanged for preferred stock of FIC $300,000 as petitioners content or $540,540 as respondent contends? • Was the fair market value of the shares of FIC transferred to Robert G Furman in 1980 was $62,016 or $147,600 as respondent contends? BVLaw, Business Valuation Resources
Court Cases (continued) • Furman v. Commissioner (continued) – part of Judge Beghe’s opinion “We do not believe that CAPM and WACC are the proper analytical tools to value a small, closely held corporation with little possibility of going public.”
Court Cases (continued) • Furman v. Commissioner (continued) “To compute WACC, it is necessary to know the market value of the firm’s debt and equity, which if known, would go far toward negating the need to perform a valuation.”; Brealey & Myers, Principals of Corporate Finance 525 (7th ed. 2003). • Expert testimony should have been rendered regarding the simplicity of determining the market value of the firm’s debt and equity. Use of electronic tools makes this process easy to determine.
Court Cases (continued) • Estate of Gallagher v. Commissioner, T.C. Memo. 2011-148, 2011 WL 2559847 (US Tax Court), June 28, 2011, Judge Halpern – The decedent owned 15% in a family-founded newspaper publishing company, which also owned a television station and a few special media providers. In 1996, the company converted to a subchapter S corporation, and just before the valuation date (July 5, 2004), it acquired a 100% interest in another small publishing company. In connection with this and other planned acquisitions, the company refinanced a $400 million debt, for which it prepared certain financial forecasts. Finally, as of July 2004, the company had nearly 3,000 executive stock options outstanding, at an average price of roughly $2,800 per option.
• The decedent’s federal estate tax return valued her 15% share at $34.9 million, based on an appraisal conducted by the company’s president and CEO. In 2007, the IRS asserted the fair market value of the decedent’s units was $49.5 million. The taxpayer petitioned the Tax Court for a redetermination based on a new appraisal of $26.6 million. Before trial, both sides enlisted new appraisers and closed the gap slightly: $28.2 million for the taxpayer versus $40.86 million for IRS BVLaw, Business Valuation Resources
Court Cases (continued) • Estate of Gallagher v. Commissioner, included in Judge Halpern’s opinion “We agree that WACC is an improper discount rate tool for a company planning to pay down its debt, thereby changing its capital structure.” See Brealey & Myers, supra at 536. “However, given the parties’ reliance on their own experts, both of whom use the WACC formula in their respective analyses, we must adopt the approach. Therefore, we will use Mr. Thomson’s constant WACC rate in this case, although we do not intend to establish a general rule in doing so.”
Court Cases (continued) • Estate of Hendrickson v. Commissioner, T.C. Memo. 1999-278, 1999 Tax Ct. Memo LEXIS 318, August 23, 1999, Judge Beghe • The issue in this estate tax case was the fair market value of decedent’s 1,499 shares of Peoples Trust and Savings Bank of Boonville, Ind., constituting 49.97% of the 3,000 shares outstanding. Decedent’s estate filed a timely Estate Tax Return Form 706, stating the value of 1,486 of the shares to be $2,126 per share. BVLaw, Business Valuation Resources
Court Cases (continued) • Estate of Hendrickson v. Commissioner – Judge Beghe in his opinion stated “CAPM is a financial model intended to explain the behavior of publicly traded securities”, and we “do not believe that CAPM and WACC are the proper analytical tools to value a small, closely held corporation with little possibility of going public.” Furman v. Commissioner, T.C. Memo. 1998-157, 75 T.C.M. (CCH) 2206, 2214, 1998 T.C.M. (RIA) par. 98-157, at 868-98.
Summary • WACC methodology • Useful when capital structure of the Subject Company is different than the industry • Iteration required to calculate market value of Debt and Equity Capital using WACC • Analyst will need to explain to the tax court and other courts why WACC is applicable methodology
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