How to calculate wacc

[afnan]

Hi, please guide me how to calculate wacc if capital structure is changing year on year and no target capital structure is give. Equity is increasing due to increase in retained earnings but long term debt is reducing over the period of 5 years.
And also, i have calculated firm value based on FCFF, FCFE and Residual income approach and there’s a question i need answer of : If Owners decide to issue 1,000,000 common shares, how much would be the value for each share??
Thanks!

 

[tickersu]

afnan wrote:
Hi, please guide me how to calculate wacc if capital structure is changing year on year and no target capital structure is give. Equity is increasing due to increase in retained earnings but long term debt is reducing over the period of 5 years.
And also, i have calculated firm value based on FCFF, FCFE and Residual income approach and there’s a question i need answer of : If Owners decide to issue 1,000,000 common shares, how much would be the value for each share??
Thanks!

What’s driving the change? If it’s a new firm that appears to be turning into an “average” firm for the industry, maybe you can look at (and use as a proxy) the average capital structure in that industry for firms that have been around for a while. I remember a capital structure paper had mentioned that industry averages for mature companies can be indicative of an “optimum” structure (if I recall). The idea arose when most surveyed managers didn’t specify an optimum or target capital structure, yet the industry seemed to converge around one.
Anyone have any comments on this?

 

[MrSmart]

Median, not average.
And no, not always, likely rarely. Capital structure changes throughout the business cycle, and different between companies depending on the underlying fundamentals, from the effective tax rate, to credit ratings. Using management guidance is most important here, depending on plans for future business outlook and funding needs. The management usually has a stance on financial policy, which you could build on to address funding surplus or deficit, while taking into account future earnings, dividend policies, debt repayments, credit quality, and interest rates. McKinsey’s valuation has an example on this in their book.
For your question, the target would be all equity since that’s the structure in perpetuity. Or you could better off use a converging valuation, but that’s above your level for now. The value of the new shares would be the value of total equity divided by the number of total new shares.

 

[tickersu]

MrSmart wrote:
Median, not average.
And no, not always, likely rarely. Capital structure changes throughout the business cycle, and different between companies depending on the underlying fundamentals, from the effective tax rate, to credit ratings. Using management guidance is most important here, depending on plans for future business outlook and funding needs. The management usually has a stance on financial policy, which you could build on to address funding surplus or deficit, while taking into account future earnings, dividend policies, debt repayments, credit quality, and interest rates. McKinsey’s valuation has an example on this in their book.
For your question, the target would be all equity since that’s the structure in perpetuity. Or you could better off use a converging valuation, but that’s above your level for now. The value of the new shares would be the value of total equity divided by the number of total new shares.

Notice, I said “average”– the mean, median, and mode are all kinds of averages (measures of central tendency, find one that’s most appropriate). The OP said there was no guidance from management (which I assumed to include no goals for how to fund projects, or whether to buy back debt, etc.). But, as I said the paper found an interesting result in the industry; no one had a target, yet the surviving firms seemed to cluster around one point, any how (if I’m remembering fully). Thanks for the feedback on that, I was curious if anyone else had heard of it!

 

[MrSmart]

Well, average tends to imply arithmatic mean.
In any case, one of the reasons why peers in industries tend to circle around a specific capital structure is not because this is most optimum, but becuase by following the capital structure of other firms, then there can be no competitive disadvantage (nor advantage). Again, companies vary (more than you think) when it comes to underlying fundamentals, from growth, to cash flow, to working capital and operating risk. Just because the AAA companies have X equity, and Y debt, does not mean it should be your target as well, but means that this is the most likely end result if your company grows far enough to be a lead player.
Studies also show that the market does not reward nor penalize companies with different leverage levels as long as they are not financially distressed. What this means is that tax savings are approximately offset by business erosion costs and higher risk that the tax savings may not be captured. Safe to say that as long as your unlevered cash flows are maximized, and your interest coverage is not down to critical levels, then capital structure is largely irrelevant. In short, a reasonable capital structure that doesn’t leave you under, or overleveraged is key. Making sure that the company has enough financial flexibility to support it’s strategy, and minimize the risk of running short on cash is the optimum capital structure to maximize shareholder value.

 

[Ron Swanson]

afnan, to get back to you questions:
1. You might actually want to consider using FCFE instead of FCFF if debt is being paid down, especially if the company is planning on paying it off. Remeber WACC assumes that as the value of a company grows its debt grows as well.
2. To calculate the value per share if the owners are selling their own shares its just the existing valuation divided by the number of shares. If the company is issuing shares (and the company will take the cash and put it to work) than you want to calculate a post money valuation and divide that by the number of shares + new shares (in your case 1,000,000)

 

[tickersu]

MrSmart wrote:
Well, average tends to imply arithmatic mean.

I agree, but thats why I clarified that it would depend on what’s driving the changes (could help you gain a better understanding of how to assess what the optimum might be). I figured you could look at the distribution of the capital structures and see what kind of average is most appropriate.
Also, about the firms clustering to avoid advantage/disadvantage– that seems like an active policy to be near the industry average. I’m not so sure that applied to the paper I’m remembering, but it could be the case.

 

[tickersu]

Ron Swanson wrote:
afnan, to get back to you questions:
1. You might actually want to consider using FCFE instead of FCFF if debt is being paid down, especially if the company is planning on paying it off. Remeber WACC assumes that as the value of a company grows its debt grows as well.

This is where I’d like to learn a bit more about the practical application. I thought that FCFE shouldn’t be used when the capital structure is changing (FCFF is more appropriate, since it’s invariant to changes in leverage). Is there a work around?

 

[MrSmart]

tickersu wrote:

Ron Swanson wrote:
afnan, to get back to you questions:
1. You might actually want to consider using FCFE instead of FCFF if debt is being paid down, especially if the company is planning on paying it off. Remeber WACC assumes that as the value of a company grows its debt grows as well.

This is where I’d like to learn a bit more about the practical application. I thought that FCFE shouldn’t be used when the capital structure is changing (FCFF is more appropriate, since it’s invariant to changes in leverage). Is there a work around?

FCFE should be (better) used when the level of future debt is known, FCFF is better used when there is a targeted capital structure proportion. FCFE is the better method overall, although it can be more difficult with changing capital structures.
But arguably, the best method that combines practicality with accuracy is the APV, then DCFE, and finally DCFF.

 

[tickersu]

MrSmart wrote:
FCFE should be (better) used when the level of future debt is known, FCFF is better used when there is a targeted capital structure proportion. FCFE is the better method overall, although it can be more difficult with changing capital structures.
But arguably, the best method that combines practicality with accuracy is the APV, then DCFE, and finally DCFF.

Right– I figured FCFE is better since it’s more direct and can be less complex (for equity valuation), but as you said, it’s more involved with dynamic capital structures. I’m pretty sure there are some books for how to apply this (aside from on-the-job learning).

 

[MrSmart]

The fact is, almost everyone does valuation wrong. The concept of WACC is practically misplaced. If the firm WACC if is all of the duration matched opportunity costs that give you today’s firm value, then how can you derive the WACC while solving for the firm value?
This is why it’s better to use APV, because duration matched WACC’s that solves for implied equity value and costs of debts can be exausting. I can link you to some papers if you’d like, you won’t find advanced finance topics in books.