登录查看更多内容

WACC and Financial Ratios Part I

Dr. Jacob Mack PhD

Experienced academic researcher, educator, cybersecurity specialist, and quantitative scientist.

发布日期: 2024年11月2日

As promised here is the first part of a three part series in Financial Accounting. I will delve first into WACC in this article and then financial ratios in part II then in the third and final part I will integrate both concepts and techniques.

The weighted average cost of capital (WACC), is still to this day an often misunderstood and abused concept within business. In simple terms, WACC is used to measure the after-tax cost of capital (rate of return needed to earn to generate a profit) from a blend of sources like: Common shares, preferred shares, and debt in the case of firms that issue shares. For private businesses it can also be calculated, but it tends to be more complex. For now we will assume corporations and firms that are publicly traded. In direct terms, WACC is the after-tax average cost for an organization to finance its entire business, multiplying each cost of each source of capital by its weighting then summing the weighted products together.

Here is the general calculation for WACC: WACC ?= ?(E/V x Re) ?+ ?((D/V x Rd) ?x ?(1 – T)).

In more condensed form: WACC??? = (Ce x E/EV) + (Cd x D/EV)

Common errors:

1.) Using book value as opposed to market value.

2.) Use long-term cost of debt as opposed to short-term for better accuracy. Consider the basis of a firm as the free cash flows projections into the distant future (perpetuity) for FCF and not just a quaterly or annual projection, or bank overdraft rate. In other words model with a sustainable long term average rate.

Now,many corporations use debt as a "debt shield" where the interest payments from the debt are tax deductible. This is where debt (loans among other sources) are used as opposed to shareholder money, but too often executives and those in the accounting or banking industry misunderstand why the cost of debt is lower than that of equity. It is only the tax shield on interest that injects a new cash flow into calculating the new valuation. The only new capital source is the tax shield. One cannot just write in more debt on a balance sheet and expect there to be a reduced cost of capital and an increase in the value of the underlying asset. In fact, as leveraging increases, while it can increase the underlying asset value to some specific limit associated with that firm, industry, and financial context, this also exerts pressure due to a larger number of external claims to that capital, so if miscalculated/over leveraged a firm can dissolve, file bankruptcy, or be taken over as we see all the time in the financial news reports.

Too often CEO's, executive management, banks who provide loans, bond sellers etc assume that if a firm is still in business today, reporting revenue, and has a favorable short term projection and a worked out WACC then they are a safe and sustainable loanee/seller of debt.

We should also keep in mind the Great Recession of late 2007-early 2010. Some cite it as 2008-2009, but the number of banks that did not pass stress tests, and the leveraging of some firms was still toxically high. It was leveraging loan companies, banks, firms, and home buyers/investors into unsustainable debt that drove the crises. The CMOs and CDOs will be a topic in a separate article. Suffice to say book keeping, assets/liabilities and various financial statements can be designed to make unsutainable debt look profitable and this is exactly what happens in mass action prior to a recession among other actions.

Summary

There is differential tax treatment of each capital component and this is used as a barometer for estimating and evaluating whether profits are being made, to make projections of future cost of capital and influx of capital within the FCF framework, and the only reason more capital can result is due to the tax shield and not some magic of debt accrual. WACC is based upon the cost of equity (ke) and the cost of debt (kd) so it needs to be model the actual corporate capital structure and proper tax rate (t). There are legitimate mistakes and errors made calculating WACC, but there is also fraudulent abuses inherent in some firm's calculations and projections. The short term rate calculations are notoriosuly innacurate, so the long-term (e.g. 10 years) should be used instead.

Jacob Mack PhD, MS, MBA, BS.