Weighted Average Cost of Capital : Clearing the Confusion for User (Part 2)

So we see in Part 1, we find that many finance websites in explaining the business valuation under Free Cash Flow to the Firm (FCFF) approach will refer to the After-Tax Weighted Average Cost of Capital (WACC), in which the Interest Tax Shield from the use of the Debt Financing will be included in the After-Tax Cost of Debt. As the Tax Authority permit the interest expense arising from the Debt incurred to be deductible against the taxable income (or in general, Earnings Before Interest and Tax (EBIT), this will reduce the corporate tax burden of the Company, as long as the Company has the positive EBIT. Interest Tax Shield could be quickly calculated from Interest Expense multiplied with Effective Corporate Income Tax, with a note the EBIT exceeds Interest Expense.

As a refresher, FCFF is the cash flow available to the Company’s providers of capital (equity and/or debt holders) after all operating expenses (including taxes) have been paid and necessary investments in net working capital (such as trade receivable, inventories and trade payable) and capital expenditure (for example, fixed assets). In short, FCFF is the cash flow from operating activities minus cash flows being used in the investing activities. Here, we will assume that the Income Tax Expense are part of Financing Activities and not reflected into the Operating Activities (though current International Financial Reporting Standards (IFRS) allows the Interest Expense be presented as part of the Cash Flows from Operating Activities. For the business valuation under FCFF approach, the Operating Activities is to be excluded from the Interest Expense at all, or in other words, it is UNLEVERED FCFF. No Debt components and its ancillary Interest Expense is in the Unlevered FCFF.

Using the above definition, consequently, we don’t see “directly” the Interest Tax Shield in Unlevered FCFF. However, if the Company has utilized Debt Financing to finance, together with Equity Financing, to fund the Project or Business, then this Interest Tax Shield should be considered and its amount should go to the Equity holders, as now the Company will pay lesser corporate income tax. Because Unlevered FCFF is the After-Tax Cash Flow available to all providers of capital to the firm, then the value of the Company (including the Interest Tax Shield) is estimated by discounting the Unlevered FCFF at the WACC.

We then have 2 (two) options to do the discounting to prevent double counting of the Interest Tax Shield:

1.??????Unlevered FCFF (in which there is NO Interest Tax Shield) discounted at After-tax WACC in which the Interest Tax Shield being included in the After-Tax Cost of Debt. ?Here it is assumed that the capital structure of the company (the proportion of Debt to Equity, or leverage ratio) is constant, or in many business valuation exercise, the valuation analyst will apply “target” capital structure to come up with D/E composition, or one single target capital structure.

2.??????We split the discounting process into 2 (two) components:

a.??????Unlevered FCFF at Before-Tax WACC (or known as Unlevered Cost of Capital (or the?cost?of?capital?for?a?project?of?an?all-equity?firm). Unlevered Cost of Capital will be higher than the After-Tax Cost of Capital as there is no (1-Tax) in the formula.

b.??????Interest Tax Shield separately addressed to be discounted at the Cost of Debt (there is a hot debate among finance professors and practitioners in many publications and textbooks about the appropriate discount rate to be used to discount Interest Tax Shield, though in general, using Professor Stewart Myers’s paper, it is the Before-tax Cost of Debt (see “Interactions of Corporate Financing and Investment Decisions—Implications for Capital Budgeting,” Journal of Finance 29 (1974): 1–25.). The second option by separately addressing the discounting of the Interest Tax Shield, this will imply that the valuation analyst could facilitate the business valuation in which the capital structure will be expected to change during the forecast period.

Prof. Stewart Myers refers the second option above as the Adjusted Present Value (APV) method, which method is explained in many corporate finance textbooks. In the APV method, the company value is estimated by summing up 2 (two) components:

1.??????The present value of the company’s FCFF under the assumption that debt is not used at all, or here Unlevered Company Value. Plus

2.??????The present value of the any effects of the use of Debt on the Company Value, prominently the tax benefits of Interest Expense. Many literatures also explores other effects of the use of Debt Financing, such as cost of financial distress.

Which approaches are better to count for the Interest Tax Shield? The first approach with the After-Tax WACC or the second approach with Before-Tax WACC and separately discounting the Interest Tax Shield using the Before-Tax Cost of Debt?

If correctly applied, both approaches should always have the same quantitative effect on the Company Value, as long as :

·??????First, the same discount rate being used to discount the Interest Tax Shield, that is Cost of Debt; and

·??????Second, the same amount of debt being used during the forecast period. Note : the use of the same target leverage (or Debt to Equity) will give rise the circular logic in the application of discounted cash flows method for FCFF.

Summing up Part 1 and Part 2 of this WACC, then it is crucial to understand that WACC as known in many finance websites and textbooks are not always necessarily followed with After-Tax WACC, or the (1-T) be included.

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