Iterating the Weighted Average Cost of Capital
When Valuators Use a Weighted Average Cost of Capital (WACC) to Determine a Discount Rate, the Rate Needs to Be â€śIterated.â€ť Hereâ€™s Why.
When an expert determines a discount rate for a controlling interest in a valuation using the Weighted Average Cost of Capital (WACC), that discount rate needs to be iterated. Since market values of debt and equity in a closely held company are not publicly traded and known, as Richard Claywell explains, the iteration process is necessary.Â Itâ€™s the only way to demonstrate the validity of using an industry average capital structure.Â Without iteration your discount rateâ€”and proposed company valueâ€”may not stand up in court.Â Hereâ€™s why.
I recently attended the deposition of an expert that had determined the value of a company and he used the Weighted Average Cost of Capital (WACC) to determine the discount rate for a controlling interest shareholder.Â The business valuation expert did not iterate the discount rate.Â Iterating means to repeat a process with the aim of approaching a desired goal, target, or result.Â The expert was asked if he had iterated the WACC to determine the discount rate. Â The attorney asked â€śYouâ€™ve never performed an iteration on a Weighted Average Cost of Capital analysis?â€ťÂ The expert responded â€śCorrect.â€ťÂ
The process of iterating consists of estimating the debt and equity structure of a company and then subtracting the debt to arrive at the invested capital of the company.Â If the invested capital is reasonably close to the book value, further iterations are not necessary.Â If the invested capital is not close to the book value, further iterations will be necessary until the market value and book value of invested capital are reasonably close.Â If this process is not performed, there will be an error in the conclusion of value.
If a minority interest is being valued, the shareholder does not have the ability to change the capital structure of the company.Â Therefore, the actual debt structure should be used without iterating the WACC.1
For a controlling interest, the beginning debt should be based on the market value of debt and equity.Â Since the closely held company is not publicly traded, the market values of the debt and equity are not known.Â These both need to be estimated through an iterative process.Â When a controlling interest is to be valued, an argument can be made to use an industry average capital structure.Â If the industry average capital structure is used, the valuator must demonstrate that the company being valued can achieve the industry averages. When the capital structure of the closely held company changes over time due to increases/decreases in profitability and cash flows, the WACC should change accordingly.Â If an iterative process is not used, the WACC does not consider the changes in the capital structure.
The valuation professional should understand the simplicity and complexities of using the WACC for both a controlling and non-controlling interest.Â If the WACC is not iterated when the changes in capital structure require it, the WACC will be incorrect and the value of the company will be either over or under stated.
J. Richard Claywell, CPA/ ABV, CVA,Â CM&AA, CFFA, ASA, ABAR, does business valuation, estate management and trust, family business, trust, and other work.Â Reach him at email@example.com
1 Pratt Shannon P., Grabowski Roger J., Cost of Capital Applications and Examples, John Wiley & Sons, Inc., Third Edition, p. 274.