Appraisal Distinctions: Earnings and Debt Play a Key Role in Determining Proper Use of Weighted Average Cost of Capital (WACC)
Choosing an Appropriate Weighted Average Cost of Capital Definition Sometimes Depends On Context
Valuation principles generally hold that the value of a business is largely a function of return on invested capital and growth, writes J. Richard Claywell, since these are the primary drivers of free cash flow. But how does this cash flow relate to the asset and liability values on the balance sheet?
This article expands on my previous article regarding iteration and provides some additional insight into the case considered.
When using a weighted average cost of capital (‚ÄúWACC‚ÄĚ), it is important to decide ‚Äúhow‚ÄĚ the WACC will be structured based on the type of engagement. If it is an ‚Äúinside‚ÄĚ deal between shareholders or a marital dissolution, then it may be appropriate to use the company‚Äôs debt-to-equity ratio. However, if it is for an M&A deal or external purpose, the valuator may consider utilizing the market debt structure for the WACC.
The valuation analyst needs to determine if the earnings and debt will remain the same or if they will change over time.
When an expert determines a discount rate for a controlling interest in a valuation using the WACC, the discount rate may or may not need to be iterated. If the equity already represents fair market value, the debt and equity does not need to be iterated. Since market values of debt and equity in a closely held company are not publicly traded and known (but they are known within the company), the iteration process may be necessary. Iteration is the way to demonstrate that the modified debt and equity market data will be a proxy for the debt to equity ratio utilized in this particular process of using an industry average capital structure. Here‚Äôs why:
I recently attended the deposition of an expert that had determined the value of a company and he used the WACC to determine the discount rate for a controlling interest shareholder. The business valuation expert did not iterate the discount rate. Iterating means to repeat a process with the aim of approaching a desired goal, target, or result. The expert was asked if he had iterated the WACC to determine the discount rate and that he had not iterated. The attorney asked, ‚ÄúYou‚Äôve never performed an iteration on a weighted average cost of capital analysis?‚ÄĚ The expert responded ‚ÄúCorrect.‚ÄĚ
It is important that the valuator determine if equity or the market value of invested capital (MVIC) will be used to determine the value of a company. In some situations, it is desirable to value more than just the common equity‚ÄĒoften all the equity and all the interest-bearing debt [sometimes referred to as the entire capital structure, the value of the company, the enterprise value, or MVIC].
In these instances, the projected cash flow (or other economic income) must include that which is available to all the components of the capital structure being valued. The discount rate must be the weighted average of the costs of each of the components of the capital structure, with the weighted average being based on the market value of each capital component. This is called the WACC. In other words, the cost of a company‚Äôs overall capital is the weighted average of the costs of all of the financing sources in its capital structure.
When using the MVIC, the process of iterating may be required, and it 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. If for the particular instance, the company‚Äôs weighted debt and equity percentages are not used (as in the case for marital dissolution, shareholder oppression, shareholder disputes, etc.), then the weighted market percentage rates would require an iterative process. Iteration is defined by Merriam-Webster as ‚Äú‚Ä¶involving repetition as (1) expressing repetition of a verbal action; or (2) relating to or being iteration of an operation or procedure.‚ÄĚ For our purposes it requires repeated specific market percentage inputs until equalization is achieved. Equalization is achieved when the market value of the debt percentage in the above equation is equal to the debt percentage as it relates to the enterprise value as a whole.
Once equalization is achieved, what is represented is the MVIC. From this value, the total interest-bearing debt must be subtracted to attain the enterprise equity value (conclusion of value) of the company.
The invested capital of a company is comprised of preferred stock, common stock, all paid-in capital, and all interest-bearing debt. Once the interest-bearing debt is subtracted from the MVIC, what remains is the equity value of the enterprise value of the company. The iteration process is repeated until there is no or a minimal change in the debt-to-equity ratio percentages.
If a minority interest is being valued, the shareholder does not have the ability to change the capital structure of the company. Therefore, the actual debt structure should be used without iterating the WACC.1
J. Richard Claywell, CPA, ABV, ASA, CBA, CVA, CM&AA, CFFA, CFD, ABAR, does business valuation, estate management and trust, family business, trust, and other work. Reach him at firstname.lastname@example.org
1 Pratt, Shannon P., Grabowski, Roger J., Cost of Capital Applications and Examples, John Wiley & Sons, Inc., Third Ed., p. 274.