Capital Structure & WACC

WACC & Capital Structure

Author: Joris Kersten MSc/ Owner Kersten Corporate Finance

Kersten Corporate Finance: M&A advisory + Business Valuations + Valuation Training

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights: Cost of Capital – A practical guide to measuring opportunity cost. 2023. M.J. Mauboussin & D. Callahan.

Introduction

In this blog series I will talk about “the cost of capital” for valuation.

This is the 4th article in this sequence.

The first one was about “the cost of debt” (23rd June 2023), you can find it on the link below:

https://www.dhirubhai.net/pulse/valuation-cost-debt-joris-kersten-msc-bsc-rab

The second one was about “the equity risk premium” (26th June 2023), you can find it on the link below:

https://www.dhirubhai.net/pulse/valuation-equity-risk-premium-joris-kersten-msc-bsc-rab

And the third one was about “betas & valuation” (4th July 2023), you can find it on the link below:

https://www.dhirubhai.net/pulse/betas-valuation-joris-kersten-msc-bsc-rab

This fourth, and last, one is about WACC & Capital Structure.

WACC

WACC (Weighted Average Cost of Capital) combines the opportunity cost of the sources of capital (debt & equity) based on target weights.

An average WACC for companies in the Russel 3000 from 1985 to 2022 was about 8 %.

(see the source I have used for this blog - Morgan Stanley - Counterpoint Global Insights)

WACC is used to discount the future free cash flows of a firm.

This is called free cash flow to firm, and outcome is the “Enterprise Value” (EV).

Please never forget that the weighting of debt and equity should be done based on market values !

And NOT on book values !

So you need to use a “target capital structure” here, based on market values !

The debt to total capital ratio for the Russell 3000 from 1985 to 2022 was on average 30 %.

So roughly 30 % market value of debt, and roughly 70 % market value of equity, on average.

The Russel 3000 shows a decline in debt levels from 2008 to about 18% debt to total capital in 2022.

Debt & equity are by far the largest sources of capital for US public companies.

And by the end of 2022, the total value of corporate debt (and leases) was roughly USD 10 Trillion.

And the market value of equity was roughly USD 40 Trillion.

( roughly 20 % debt / roughly 80 % equity at the end of 2022 )

Debt to total capital ratio

In general, businesses with low “business risk” are good candidates to use debt.

Business risk reflects the volatility of operating profits and is measured with “unlevered beta”.

The valuation expert; Aswath Damodaran, analyses the relationship between unlevered beta and the ratio of debt to total capital.

He does this for more than 90 industries.

And as the theory predicts, the outcomes are:

• Companies with low business risk (low unlevered beta) tend to have higher debt to total capital ratios than firms with high business risk (high unlevered beta).

This is consistent with so called “trade off theory”.

This theory tells us that firms will use a significant level of debt, if possible, because debt is cheaper than equity.

And this lowers the WACC !

But of course, you can only use debt to a certain extent.

On debt you pay interest.

And think of interest as a fixed cost, it declines operating profit, and can result in losses, when there is too much debt (interest).

Low risk businesses can handle this (interest) cost better, as above research shows.

So they have an intention to use more cheap debt !

Capital structure

Concerning capital structure, you can finance a business internally through cash from operations.

And you can raise debt and/ or equity.

A company can rely on internal financing when its (NOPAT) growth rate is equal, or lower, than its return on invested capital (ROIC).

(see my previous blogs on ROIC to find out how this works mathematically, I have explained this extensively before)

Expert valuator Aswath Damodaran tested this.

The hypothesis was that (with holding growth constant):

• Businesses with high ROICs have lower debt to total capital ratios compared to businesses with low ROICs.

Reason would be that companies would use internal financing before debt financing, because it comes first in the "pecking order".

So this way of reasoning is called “pecking order theory”.

And research shows that this (basic pattern) holds true:

Many of the best businesses in the world (as measured by ROIC), have very conservative capital structures !

This was the 4th, and last, blog on the cost of capital.

Hope it was useful, see you next week again with a new blog on valuation and/ or M&A.

Best regards, Joris Kersten

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights: Cost of Capital – A practical guide to measuring opportunity cost. 2023. M.J. Mauboussin & D. Callahan.