The eighth and last article in this series on the weighted average cost of capital (WACC) discusses how to increase shareholder value by utilizing tax opportunities. Generally, shareholder value can be created by either:

• Increasing operational cash flows, which is similar to increasing the net operating profit ‘after-tax’ (NOPAT);
• or Reducing the ‘after-tax’ WACC.

This article starts by focusing on the relationship between the WACC and tax. Best market practice is to reflect the actual environment in which a company operates, therefore, the general WACC equation needs to be revised according to local tax regulations. We will also outline strategies for utilizing tax opportunities that can create shareholder value. A reduction in the effective tax rate and in the cash taxes paid can be achieved through a number of different techniques.

Relationship Between WACC and Tax

Within their treasury and finance activities, multinational companies could trigger a number of different taxes, such as corporate income tax, capital gains tax, value-added tax, withholding tax and stamp or capital duties. Whether one or more of these taxes will be applicable depends on country specific tax regulations. This article will mainly focus on corporate tax related to the WACC. The tax treatment for the different capital components is different. In most countries, the cost of debt is tax deductible while the cost of equity isn’t (for hybrids this depends on each case).

The corporate tax rate in the general WACC equation, discussed in the first article of this series (see Part 1: Is Estimating the WACC Like Interpreting a Piece of Art?), is applicable to debt financing. It is appropriate, however, to take into consideration the fact that several countries apply thin capitalization rules that may restrict tax deductibility of interest expenses to a maximum leverage.

Furthermore, in some countries, expenses on hybrid capital could be tax deductible as well. In this case the corporate tax rate should also be applied to hybrid financing and the WACC equation should be changed accordingly.

Finally, corporate tax regulation can also have a positive impact on the cost of equity. For example, Belgium has recently introduced a system of notional interest deduction, providing a tax deduction for the cost of equity (this is discussed further in the section below: Notional Interest Deduction in Belgium).

As a result of the factors discussed above, we believe that the ‘after-tax’ capital components in the estimation of the WACC need to be revised for country specific tax regulations.

Revised WACC Formula

In other coverage of this subject, a distinction is made between the ‘after-tax’ and ‘pre-tax’ WACC, which is illustrated by the following general formula:

WACC_PT = WACC_AT / [1 – TC]

WACC_AT : Weighted average cost of capital after-tax
WACC_PT : Weighted average cost of capital pre-tax
TC : Corporate income tax rate

In this formula the ‘after-tax’ WACC is grossed-up by the corporate tax rate to generate the ‘pre-tax’ WACC. The correct corporate tax rate for estimating the WACC is the marginal tax rate for the future! If a company is profitable for a long time into the future, then the tax rate for the company will probably be the highest marginal statutory tax rate.

However, if a company is loss making then there are no profits against which to offset the interest. The effective tax rate is therefore uncertain because of volatility in operating profits and a potential loss carry back or forward. For this reason the effective tax rate may be lower than the statutory tax rate. Consequently, it may be useful to calculate multiple historical effective tax rates for a company. The effective tax rate is calculated as the actual taxes paid divided by earnings before taxes.

Best market practice is to calculate these rates for the past five to ten years. If the past historical effective rate is lower than the marginal statutory tax rate, this may be a good reason for using that lower rate in the assumptions for estimating the WACC.

This article focuses on the impact of corporate tax on the WACC but in a different way than previously discussed before. The following formula defines the ‘after-tax’ WACC as a combination of the WACC ‘without tax advantage’ and a ‘tax advantage’ component:

WACC_AT = WACC_WTA – TA

WACC_AT : Weighted average cost of capital after-tax
WACC_WTA : Weighted average cost of capital without tax advantage
TA : Tax advantage related to interest-bearing debt, common equity and/or hybrid capital

Please note that the ‘pre-tax’ WACC is not equal to the WACC ‘without tax advantage’. The main difference is the tax adjustment in the cost of equity component in the pre-tax calculation. As a result, we prefer to state the formula in a different way, which makes it easier to reflect not only tax advantages on interestbearing debt, but also potential tax advantages on common equity or hybrid capital.

The applicable tax advantage component will be different per country, depending on local tax regulations. An application of this revised WACC formula will be further explained in a case study on notional interest deduction in Belgium.

Notional Interest Deduction in Belgium

Recently, Belgium introduced a system of notional interest deduction that provides a tax deduction for the cost of equity. The ‘after-tax’ WACC formula, as mentioned earlier, can be applied to formulate the revised WACC equation in Belgium:

WACC_AT = WACC_WTA – TA

WACC_WTA : Weighted average cost of capital without tax advantage, formulated as follows: R_D x D_M / [D_M+E_M] + R_E x E_M / [D_M+E_M] TA : Tax advantage related to interest-bearing debt and common equity, formulated as follows: TC x [R_D x D_M + R_N x E_B] / [D_M+E_M] TC : Corporate tax rate in Belgium
R_D : Cost of interest-bearing debt
R_E : Cost of common equity
R_N : Notional interest deduction
D_M : Market value of interest-bearing debt
E_M : Market value of equity
E_B : Adjusted book value of equity

The statutory corporate tax rate in Belgium is 33.99%. The revised WACC formula contains an additional tax deduction component of [RN x EB], which represents a notional interest deduction on the adjusted book value of equity. The notional interest deduction can result in an effective tax rate, for example, intercompany finance activities of around 2-6%.

The notional interest is calculated based on the annual average of the monthly published rates of the long-term Belgian government bonds (10-year OLO) of the previous year. This indicates that the real cost of equity, e.g. partly represented by distributed dividends, is not deductible but a notional risk-free component.

The adjusted book value of equity qualifies as the basis for the tax deduction. The appropriate value is calculated as the total equity in the opening balance sheet of the taxable period under Belgian GAAP, which includes retained earnings, with some adjustments to avoid double use and abuse. This indicates that the value of equity, as the basis for the tax deduction, is not the market value but is limited to an adjusted book value.

As a result, Belgium offers a beneficial tax opportunity that can result in an increase of shareholder value by reducing the ‘after-tax’ WACC. Belgium is, therefore, on the short-list for many companies seeking a tax-efficient location for their treasury and finance activities. Furthermore, the notional interest deduction enables strategies for optimizing the capital structure or developing structured finance instruments.

How to Utilize Tax Opportunities?

This article illustrates the fact that managing the ‘after-tax’ WACC is a combined strategy of minimizing the WACC ‘without tax advantages’ and, at the same time, maximizing tax advantages. A reduction in the effective tax rate and in the cash taxes paid can be achieved through a number of different techniques. Most techniques have the objective to obtain an interest deduction in one country, while the corresponding income is taxed at a lower rate in another country. This is illustrated by the following two examples.

The first example concerns a multinational company that can take advantage of a tax rate arbitrage obtained through funding an operating company from a country with a lower tax rate than the country of this operating company. For this reason, many multinational companies select a tax-efficient location for their holding or finance company and optimize their transfer prices.

Secondly, country and/or company specific hybrid capital can be structured, which would be treated differently by the country in which the borrowing company is located than it would be treated by the country in which the lending company is located. The potential advantage of this strategy is that the expense is treated as interest in the borrower’s country and is therefore deductible for tax purposes.

However, at the same time, the country in which the lender is located would treat the corresponding income either as a capital receipt, which is not taxable or it can be offset by capital losses or other items; or as dividend income, which is either exempt or covered by a credit for the foreign taxes paid. As a result, it is beneficial to optimize the capital structure and develop structured finance instruments.

There is a range of different strategies that may be used to achieve tax advantages, depending upon the particular profile of a multinational company. Choosing the strategy that will be most effective depends on a number of factors, such as the operating structure, the tax profile and the repatriation policy of a company. Whatever strategy is chosen, a number of commercial aspects will be paramount. The company will need to align its tax planning strategies with its business drivers and needs.

The following section highlights four practical strategies that illustrate how potential tax advantages and, as a consequence, an increase in shareholder value can be achieved by:

• Selecting a tax-efficient location.
• Optimizing the capital structure.
• Developing structured finance instruments.
• Optimizing transfer prices.

Selecting a tax-efficient location

Many companies have centralized their treasury and finance activities in a holding or separate finance company. Best market practice is that the holding or finance company will act as an in-house bank to all operating companies. The benefit of a finance company, in comparison to a holding, is that it is relatively easy to re-locate to a tax-efficient location. Of course, there are a number of tax issues that affect the choice of location. Selecting an appropriate jurisdiction for the holding or finance company is critical in implementing a tax-efficient group financing structure.

Before deciding to select a tax-efficient location, a number of issues must be considered. First of all, whether the group finance activities generate enough profit to merit re-locating to a low-tax jurisdiction. Secondly, re-locating activities affects the whole organization because it is required that certain activities will be carried out at the chosen location, which means that specific substance requirements, e.g. minimum number of employees, have to be met. Finally, major attention has to be paid to compliance with legal and tax regulation and a proper analysis of tax-efficient exit strategies. It is advisable to include all this information in a detailed business case to support decision-making.

When selecting an appropriate jurisdiction, several tax factors should be considered including, but not limited to, the following: The applicable taxes, the level of taxation and the availability of special group financing facilities that can reduce the effective tax rate.

• The availability of tax rulings to obtain more certainty in advance.
• Whether the jurisdiction has an expansive tax treaty network.
• Whether dividends received are subject to a participation exemption or similar exemption.
• Whether interest payments are restricted by a thin capitalization rule.
• Whether a certain controlled foreign company (CFC) rule will absorb the potential benefit of the chosen jurisdiction.

Other important factors include the financial infrastructure, the availability of skilled labor, living conditions for expatriates, logistics and communication, and the level of operating costs.

Based on the aforementioned criteria, a selection of attractive countries for locating group finance activities is listed below:

Belgium: In 2006, Belgium introduced a notional interest deduction as an alternative for the ‘Belgian Co-ordination Centres’. This regime allows taxefficient equity funding of Belgian resident companies and Belgian branches of non-resident companies. As a result, the effective tax rate may be around 2-6%.

Ireland: Ireland has introduced an attractive alternative to the previous ‘IFSC regime’ by lowering the corporate income tax rate for active trading profits to 12.5%. Several treasury and finance activities can be structured easily to generate active trading profit taxed at this low tax rate.

Switzerland: Using a Swiss finance branch structure can reduce the effective tax rate here. These structures are used by companies in Luxembourg. The benefits of this structure include low taxation at federal and cantonal level based on a favorable tax ruling – a so called tax holiday – which may reduce the effective tax rate to even less than 2%.

The Netherlands: Recently, the Netherlands proposed an optional tax regulation, the group interest box, which is a special regime for the net balance of intercompany interest within a group, taxed at a rate of 5%. This regulation should serve as a substitute for the previous ‘Dutch Finance Company’.

Optimizing the capital structure

One way to achieve tax advantages is by optimizing not only the capital structure of the holding or finance company but that of the operating companies as well. Best market practice is to take into account the following tax elements:

Thin capitalization: When a group relationship enables a company to take on higher levels of debt than a third party would lend, this is called thin capitalization. A group may decide to introduce excess debt for a number of reasons. For example, a holding or finance company may wish to extract profits tax-efficiently, or may look to increase the interest costs of an operating company to shelter taxable profits.

To restrict these situations, several countries have introduced thin capitalization rules. These rules can have a substantial impact on the deductibility of interest on intercompany loans.

Withholding tax: Interest and dividend payments can be subject to withholding tax, although in many countries dividends are exempt from withholding tax. As a result, high rates of withholding tax on interest can make traditional debt financing unattractive. However, tax treaties can reduce withholding tax. As a consequence, many companies choose a jurisdiction with a broad network of tax treaties.

Repatriation of cash: If a company has decided to centralize its group financing, then it is relevant to repatriate cash that can be used for intercompany financing. In most countries, repatriation of cash can be performed through dividends, intercompany loans or back-to-back loans. It depends on each country what will be the most tax-efficient method.

Developing structured finance instruments

Developing structured finance instruments can be interesting for funding or investment activities. Examples of structured finance instruments are:

Hybrid capital instruments: Hybrid capital combines certain elements of debt and equity. Examples are preferred equity, convertible bonds, subordinated debt and index-linked bonds. For the issuers, hybrid securities can combine the best features of both debt and equity: tax deductibility for coupon payments, reduction in the overall cost of capital and strengthening of the credit rating.

Tax sparing investment products: To encourage investments in their countries, some countries forgive all or part of the withholding taxes that would normally be paid by a company. This practice is known as tax sparing. Certain tax treaties consider spared taxes as having been paid for purposes of calculating foreign tax deductions and credits. This is, for example, the case in the tax treaty between The Netherlands with Brazil, which enables the structuring of tax-efficient investment products.

Double-dip lease constructions: A double-dip lease construction is a cross-border lease in which the different rules of the lessor’s and lessee’s countries let both parties be treated as the owner of the leased equipment for tax purposes. As a result of this, a double interest deduction is achieved, also called double dipping.

Optimizing transfer prices

Transfer pricing is generally recognized as one of the key tax issues facing multinational companies today. Transfer pricing rules are applicable on intercompany financing activities and the provision of other treasury and finance services, e.g. the operation of cash pooling arrangements or providing hedging advice.

Currently, in many countries, tax authorities require that intercompany loans have terms and conditions on an arm’s length basis and are properly documented. However, in a number of countries, it is still possible to agree on an advance tax ruling for intercompany finance conditions.

Several companies apply interest rates on intercompany loans, being the same rate as an external loan or an average rate of the borrowings of the holding or finance company. When we apply the basic condition of transfer pricing to an intercompany loan, this would require setting the interest rate of this loan equal to the rate at which the borrower could raise debt from a third party.

In certain circumstances, this may be at the same or lower rate than the holding or finance company could borrow but, in many cases, it will be higher. Therefore, whether this is a potential benefit depends on the objectives of a company. If the objective is to repatriate cash, then a higher rate may be beneficial.

Transfer pricing requires the interest rate of an intercompany loan to be backed up by third-party evidence, however, in many situations this may be difficult to obtain. Therefore, best market practice is to develop an internal credit rating model to assess the creditworthiness of operating companies.

An internal credit rating can be used to define the applicable intercompany credit spread that should be properly documented in an intercompany loan document. Furthermore, all other terms and conditions should be included in this document as well, such as, but not limited to, clauses on the definition of the benchmark interest rate, currency, repayment, default and termination.

Conclusion

This article began with a look at the relationship between the WACC and tax. Best market practice is to revise the WACC equation for local tax regulations. In addition, this article has outlined strategies for utilizing tax opportunities that can create shareholder value. A reduction in the effective tax rate, and in the cash taxes paid, can be achieved through a number of different techniques.

This eight-part series discussed the WACC from different perspectives and how shareholder value can be created by strategic decision-making in one of the following areas:

Business decisions: The type of business has, among others, a major impact on the growth potential of a company, the cyclicality of operational cash flows and the volume and profit margins of sales. This influences the WACC through the level of the unlevered beta.

Treasury and finance decisions: Activities in the area of treasury management, risk management and corporate finance can have a major impact on operational cash flows, capital structure and the WACC.

Tax decisions: Utilizing tax opportunities can create shareholder value. Potential tax advantages can be, among others, achieved by selecting a taxefficient location for treasury and finance activities, optimizing the capital structure, developing structured finance instruments and optimizing transfer prices.

Based on this overview we can conclude that the WACC is one of the most critical parameters in strategic decision-making.

This article describes the reasons behind the increased interest among corporates in using hybrid instruments to optimize their capital structure and the impact of hybrids on the WACC and shareholder value. It also takes a look at treatment by accountants, tax regulation and rating agencies.

Over €8bn of capital was raised in 2005 by corporates in Europe in the hybrid category, according to The Treasurer, April 2006. Over the past decade, it has primarily been financial institutions who have been frequent issuers of hybrids to optimize their capital structure. However, corporates are now also increasingly tapping this segment.

This growing interest can be explained both by new insights regarding the accounting and rating benefits of these instruments, as well as an increased appetite by investors who are drawn by the opportunity to make an additional yield in the current low-interest rate and credit spreads environment.

Accounting Treatment

A hybrid instrument can be structured to achieve equity treatment from an IFRS perspective. IAS 32 (Financial Instruments: Disclosure and Presentation) requires a hybrid to have optional payment for all coupons and that the instrument should have no defined economic maturity.

If the instrument is structured to achieve equity accounting, the coupon is accounted for as a ‘preferred’ dividend distribution. This way, there is no interest expense and the reported net income is not affected. Likewise, earnings per share (EPS) are unchanged as for the purposes of the EPS calculation, preferred dividends are deducted from earnings.

However, if the instrument is treated as equity there is no IAS 39 (Financial Instruments: Recognition and Measurement) hedge accounting available for any associated swaps. The resulting P&L volatility may lead issuers to choose to have the instruments structured so that they are accounted for as debt.

View of Rating Agencies

Credit rating agency Moody’s published its Tool Kit for Assessing Hybrid Securities, a framework to determine the relative debt and equity characteristics of hybrid instruments, in December 1999. Since then, the rating agency has assessed hundreds of instruments, positioning them along the debtequity continuum in baskets from A (more debtlike) to E (more equity-like). Each basket on this continuum translates into the following percentages of equity and debt for the purpose of financial ratio calculations:

To illustrate, a €100m hybrid placed by Moody’s in Basket D will result in a €75m increase in equity and a €25m increase in debt. All relevant ratios, which include either debt or equity, will be adjusted accordingly by the agency.

In February 2005, Moody’s announced its revised methodology for the category, significantly increasing the acknowledgement of the equity-like features of the instruments and rewarding higher equitycredit to structures which meet specifically required features, particularly regarding subordination, coupon deferral and permanence in the capital structure. Moody’s revision has made it possible for corporates to achieve meaningful equity-credit of 50 per cent or more, and has prompted increased corporate activity in this area.

Standard & Poor’s and Fitch Ratings have also clarified their thinking on hybrids, and the three big rating agencies are now roughly in line in their treatment of hybrid capital.

Tax Treatment

The recent flow of corporate transactions has started in Europe thanks to favourable tax legislation in several European countries that makes it easier than in the US to develop new hybrid products that both improve rating treatment and qualify as debt for tax purposes. In the UK, however, the corporate tax law contains several provisions that challenge the tax deduction on interest paid on debt with ‘excessive’ equity characteristics.

The potential to achieve a more robust tax opinion may lead issuers choosing to have the instrument structured to be accounted for as debt. In article seven of this series on the WACC, ‘Reducing the WACC by Utilizing Tax Opportunities’; more tax angles related to this topic will be covered.

Impact on the WACC and Shareholder Value

Optimizing the WACC and maximizing returns to shareholders is a top priority for corporate treasurers.

Hybrid instruments strengthen the capital base by creating a buffer between senior creditors and shareholders. Hybrid capital offers an opportunity, when correctly structured and used as a substitute for more expensive and less flexible common equity, to lower the WACC.

Hybrid issues typically price between 50 and 200 basis points over senior debt. This means that the marginal cost of funding can be significantly lower than funding achieved through traditional debt and equity funding sources. This cost-effectiveness can be illustrated with the following example.

A company wants to raise €100m of capital with half of it qualifying as equity for rating purposes. It has, simply put, two options:

1. €50m each of traditional debt and equity.
2. €100m of hybrid capital with an equity treatment by the rating agencies of 50 per cent.

We assume the following rates apply to this company:

The marginal cost of capital for option 1 (traditional capital) would be:

The marginal cost of capital for option 2 (hybrid capital) would be

Please note: this calculation assumes full tax deductibility of the hybrid instrument.

By issuing hybrid capital with 50 per cent equity treatment the company achieves a cost of capital saving of 2.4 per cent. The advantage could be bigger still with 75 per cent equity treatment. The example shows that when hybrids are applied to substitute expensive equity, they offer an opportunity to lower the WACC of the issuer.

Conclusion

Hybrids offer corporates the opportunity to strengthen or maintain their credit ratings and balance sheet ratios, while funding acquisitions, share repurchases or pension deficits.

The economics achievable in current markets are an additional driving factor in the continuing rise in the number of hybrid instruments issued by corporates.

As a non-dilutive instrument, hybrid capital is particularly suitable for issuers who have limited access to equity or have dilution concerns. Raising hybrid capital offers the opportunity to lower the marginal cost of capital and therefore increase the return to shareholders.

To return to the question in the title of this article, hybrid capital can indeed be considered cheap equity. The additional cost on top of the normal cost of senior debt does not preclude the potential overall reduction in the cost of capital.

For companies with sufficient debt capacity within their current ratings, however, raising cheaper financing (not only in terms of spreads but also in terms of upfront fees) through traditional debt markets could still be a more attractive option. Possible changes in tax regimes and rating methodologies should also be taken into account when deciding on which funding instrument to choose.

Best Practice for WACC Estimation in Emerging Markets

The prospect of emerging markets, mainly driven by high growth potential, draws the attention of a corporate in search for investment opportunities. But often there is a lack of correct appraisal of both these investment opportunities, and the risks involved with the execution of the projects.

The CFO and treasurer play a vital role in assessing the quality of the investment proposals by setting the appropriate hurdle rate for project selections, to make sure shareholder value will be created given the risks involved.

The first article in the WACC series extensively describes the components that comprise the weighted average cost of capital and how to estimate the WACC.

Part six of the WACC guide will now show methods of how to deal with, and quantify, risks and features of emerging markets when estimating the WACC for foreign investment decisions and appraisals.

Which Discount Rate to Use?

One question that a company investigating a foreign investment in an emerging market should ask is: which hurdle rate should be used? Should a separate project WACC be calculated for this operation? Or, can just the corporate WACC be applied, added with a premium or discount to compensate for different inflation levels?

There are basically three different types of discount rate:

The first method is to use the corporate WACC. Supporters in favor of using one single corporate WACC argue that a multinational company can be considered as a portfolio of multiple (global) investments and therefore each investment can be treated with the same cost of capital, which reflects the company’s total aggregated portfolio risks.

This approach acknowledges the advantage of a multinational, which is able to diversify country specific risks somewhat when volatilities in different countries are partly off-set by each other due to their low correlation. The appropriate WACC for operating in an emerging market this way is the corporate WACC adjusted for the marginal contributing effect of the operation in the emerging market (based on the specific financial and operational leverage). When calculating of the nominal WACC in the foreign currency, a compensation for the different levels of inflation between the home and foreign currency will have to be added or deducted.

The second method is to consider each investment project as a stand-alone investment and value each of them according to a local WACC that reflects the risks of the local country and project. In that respect there is one major argument that demonstrates the need to calculate an individual WACC for an emerging market – emerging markets are, to some extent, non-integrated markets (not integrated with the global market). It is therefore said to be a segmented market.

The characteristic of a segmented market is that real returns (compensated for different levels of inflation) are also determined by domestic risk factors. These are characterized by inefficiencies caused by regulatory, legal and tax barriers in emerging markets.

These inefficiencies have an impact on the cost of equity. In such a case, the company determines a local project WACC, with a local cost of equity the measure of a country’s equity risk levels for the operations in the emerging markets, rather than the corporate WACC.

The third method is a ‘middle-of-the-road’ approach, which acknowledges the need to account for the additional sovereign risk factors in the country of the investment in the WACC. This is achieved by simply adding a sovereign risk premium to the corporate WACC as a markup.

Sovereign risk represents the country risk and the credit risk of the country. Simply put, the sovereign risk premium is the difference between the yield of the risk-free triple-A rated government bond and a bond issued by the local government (with the sovereign risk embedded in it) minus the inflation differential of the two currencies involved. If local bonds are issued in US$, the inflation differential should not be deducted.

The major disadvantage of adding a sovereign risk premium is that it primarily reflects the sovereign default risk and can hence serve little to quantify the exact measure of equity risk in that country. To some extent it will cover the additional market risk premium (MRP) for an emerging market, but not the total MRP.

The preferred method out of the three presented is therefore the second method that calculates a separate cost of equity and consequently a separate local WACC for the investment in the emerging market.

How is Risk Reflected in the WACC and in Cash Flow?

We have established that the preferred discount rate requires a separate WACC to be calculated for investments in emerging markets to reflect the additional risks.

The question is, which of all these additional risk factors in emerging markets are included in the cost of equity (Re) and the cost of debt (Rd) of the WACC, and which risk factors should be reflected in the projected cash flows?

Best practice is that operational risk, which is diversifiable (non-systematic), should be accounted for in the cash flow projections. Industry and country risk, which can not be eliminated by diversification (systematic risk), should be incorporated in the WACC. The industry risk is captured in the beta of the company (adjusted for the capital structure of the company).

Typical non-systematic risks include many operational challenges associated with investments in emerging markets. Included in the cash flow will also be incremental costs associated with investments in emerging markets, like insurance costs, legal costs and costs for currency repatriation and hedging.

Typical systematic risks in an emerging market include default, political and country specific economic risks and, in case of equity investments, one will also have to account for inefficient markets.

Expected inflation should be treated separately from the aforementioned sovereign risk and market inefficiencies. Whether inflation should be taken into account depends on whether the WACC is calculated in the base currency of the company or in the local currency. In the case of the latter the inflation differential will have to be added on top of the sovereign risk premium.

It is important to mention that inflation rates should be included in the discount rate as well as in the cash flow. Numerator and denominator calculations should be based on the same inflation rates, to avoid any mismatches.

Specific Risk Adjustments in the WACC

Calculating the WACC in developed markets can be a difficult exercise, but the calculation in emerging market environments is even more challenging. As well as the different and additional risks mentioned, emerging markets are also less developed, liquid and consequently less efficient. In other words, reliable information for the determination of the WACC will be harder to obtain. The next section will discuss the specific adjustments for additional risks and uncertainties in the components that comprise the WACC, which need to be taken into account

1. Cost of equity (Re):

The first component of the WACC is the cost of equity. In developed markets the capital asset pricing model (CAPM) is mostly applied to estimate the cost of equity of an investment. But CAPM has one important underlying theoretical assumption, which is that it assumes that markets are fully integrated and efficient. However, there is evidence to conclude that emerging markets are not efficient.

For fully segmented emerging markets it can even be argued that CAPM is unsuitable for estimating the cost of equity, as the equity prices are not determined by equilibrium situations due to inefficiencies and poor liquidity. However, since there is a lack of alternative methodologies to determine Re in emerging markets, CAPM is still mostly applied. In order to make CAPM suitable for emerging markets, the following factors in CAPM should be taken with care and will have to be adjusted to represent the additional risks of the partly segmented emerging markets:

Risk-free rate (Rf):
In developed markets, the 10 year government bond is the basis for CAPM calculation. But since emerging markets have a rating below triple-A, the government bonds themselves are not risk-free and they incorporate a sovereign risk premium. Another issue, which especially exists in high inflation environments, is that long-term government bonds are usually unavailable.

Beta (β):
The β in the CAPM equation provides a quantification of the sensitivity (systematic risk) of an investment project to market movements. When a beta is unknown, it is hard to properly determine in emerging markets. Sometimes companies or industries beta’s are not calculated locally, since it is likely that betas and stock returns are less correlated due to a lack of information and market inefficiencies. But there is an alternative, namely to use the global industry β, re-levered to the company’s appropriate target leverage.

Market risk premium (MRP):
The MRP is the extra return that the stock market provides over the risk-free rate to compensate for market risk.

In developed integrated markets historically derived market risk premium is estimated to be around 5%. The problem in emerging markets is that reliable data records to determine the return rates are unavailable in many cases.

Then, once you have determined the historic risk premium based on the recorded data, you also have to question whether these records are a reliable predictor for the long-term future.

Historic averages in emerging markets are often influenced by periods of high volatility. In case that historic data series show periods of extreme volatility in premiums, a downward adjustment is recommendable. Therefore these premiums should be taken with care and the historic riskpremium should subsequently be adjusted according to the prospects. There is an alternative approach often used to determine the additional market risk premium for an emerging market.

Take the market risk premium of the developed domestic market and add the sovereign risk premium, multiplied by the ratio of the standard deviation on returns of the country’s equity market, divided by the standard deviation on the local government bond.

2. Cost of debt (Rd):

The cost of debt is the second component in the WACC. It is the marginal cost that needs to be offered to raise additional capital in the form of debt, including the issuance costs of the concerning debt. Additionally, the local capital market for debt in an emerging market will show inefficiencies, and is often regulated. Consequently, in case local debt sources are used, the actual cost of debt can be substantially different to what it would have been according to the company’s credit rating.

Reliable long-term interest rates in emerging markets are rarely available and, as a result, only short-term debt will be available as a reference. Sometimes in a high inflation environment, debt instruments are dollarized or inflation indexed.

In some emerging countries it might even be impossible to obtain debt financing. This implies that a company can only invest through equity.

The chosen capital structure in an emerging market is rarely based on a free will. Restrictions to foreign ownership and a lack of availability of debt instruments or borrowing restrictions from local banks will all have an impact on the actual capital structure.

Project Appraisals

The WACC is widely applied as the discount rate to measure the quality of investments with help of the discounted cash flow method (DCF). The WACC is the proper discount rate for discounting future cash flows into a present value.

In normal circumstances, a company must seek to make a return on its investments in excess of, or at least equal to, the WACC (or a positive net present value).

The DCF-method applied for valuations in emerging markets deviates from the same method in developed markets, as in emerging markets you also have to deal with additional risks that may affect the certainty of future cash flows. It is therefore recommended to model a scenario or sensitivity based DCF for emerging market valuations. This should explicitly incorporate the non-systematic risks involved in the operation in the emerging market.

The impact of future cash flow risk should be carefully assessed, as some risks do not apply equally to industries or companies. An example can be the depreciation or appreciation of a currency. An importing company will be impacted differently by an appreciation than an exporting company.

Apart from exchange rates, the development of other economic variables can heavily impact future cash flow. This can include inflation, GDP and interest. In order to identify the impact of these variables, one can conduct a sensitivity analysis.

Next to the systematic and the non-systematic risks discussed earlier, another important feature of emerging markets are the often high levels of inflation.

There are in principle two methods how to cope with inflation in a DCF-calculation:

1. Nominal prices method:
In this method the inflation is both accounted for in the cash flows and in the discount rate.

2. Real prices method:
This approach takes into account the financial statements in real terms and consequently discounts the cash flows in real terms against the real discount rate.

The major benefit here is that it is somewhat easier to forecast future cash flows in real terms than in nominal terms, especially in environments that face high and variable levels of inflation. It is sometimes said that when inflation levels reach double digit figures it is preferable to model the forecast on real terms. Obviously when cash flows are calculated in real terms, the discount rate should be on real terms as well to avoid a mismatch.

Exchange rates are another element that need to be taken into account in a nominal forecast. In the case of imports and exports of goods in foreign currencies, there are exchange rates involved in the valuation.

You will have to take into account that the exchange rates in your valuations are impacted by the inflation rates among other items (according to purchasing power theory), although exchange rates might only be adjusted for the interest differential in the longrun.

A single discount factor (WACC) for DCF calculation in emerging markets will lead to an over-simplistification that ignores the dynamics of an emerging market. In emerging markets, with high levels of uncertainty and variability of inflation and capital structure, it’s recommended to calculate a nominal WACC per year reflecting the developments in inflation and capital structure and risk premiums. The level of inflation applied in the WACC should also be reflected in the discounted cash flows.

Conclusions

The major distinction between developed markets and emerging markets is the increased level of risk, caused by macro economic variables, volatility and inefficiencies in capital markets and political situations. There are many different ways to incorporate and account for these additional risks.

A mark-up on the domestic corporate WACC, for the sovereign risks and inflation differential, will not be sufficient to calculate the required compensation for the additional equity risks involved. Best practice is therefore to calculate a local WACC, which not only fully reflects the company specific risks but also the equity and debt market risk of the country of investment. The different components of the WACC will have to be adjusted for the risks involved.

Since emerging markets are rapidly changing, the WACC will consequently also change over time. A point estimation of the WACC should therefore be taken with care, especially when used in DCF’s for project appraisals.
The CFO and treasurer will play an important role in the strategic process of project analysis in emerging markets, not only by quantifying the specific risks involved with investment in a particular country in the estimation of the WACC, but also by determining and quantifying the risks on the foreign cash flows.

In a perfect financial world, risk management would be irrelevant for shareholders with regard to shareholder value. Risk management would not add any value in this perfect world because each participant would have equal access to the capital markets and there would be less financial distress.

This scenario is the so-called Modigliani-Miller world in which the shareholder would be able to achieve the same value by applying their own hedging strategy because they would have access to the same information as the company and, as a result, no hedging cost.

The real financial world, however, is rarely as perfect as an academic model. Capital markets do suffer from imperfections, such as information asymmetries, agency costs, transaction costs and taxes. Because of these influences, hedging costs are lower in the case where a company hedges itself rather than when individual shareholders take the same action. It is therefore possible for a company to create shareholder value by professional corporate risk management in a way that is impossible for shareholders on their own.

Ways to Add Value with Risk Management

The objective of risk management for most corporates is to reduce the influence of external financial variables on the company’s earnings volatility (in the short term). The financial variables for which the treasurer is responsible normally include interest rates and foreign exchange rates but can also include commodity prices, inflation levels or even the outside temperature.

This article will show how risk management can add shareholder value by means of lowering the WACC by breaking down the WACC formula into the different components where the risk-free rate and market premium are taken as given (Part 1: Is Estimating the WACC Like Interpreting a Piece of Art?). In its basic form the WACC formula is:

D: Market value of interest-bearing debt
E: Market value of common equity
RD: Cost of interest-bearing debt
RE: Cost of common equity
Ô: Corporate tax rate

The article will also look at the relationship between risk management and the cost of equity, cost of debt, effective tax rate, and optimal leverage.

1. Lower the cost of equity by lowering the beta of the company

A risk reduction leads to a reduction in the required return of the shareholders. Obviously, lower required returns on equity are not value creating in their own right but when combined with the other effects on the WACC, as described below, they offer possibilities to increase shareholder value.

2. Lowering the cost of debt

The cost of debt is based on the prevailing market rates plus a company-specific credit spread.

The relationship between the cost of debt and risk management is twofold. First, with regard to interest rate risk, one of the objectives of corporate risk management is to lower the absolute interest cost.

This can be done in a tactical way by active interest rate risk management where the objective is to reduce the nominal interest expenses and thereby the cost of debt. Secondly, the outcome of active interest rate risk management affects the cost of debt of a company.

The cost of debt and especially the company-specific credit spread are determined, among other factors, by cash flow and accounting ratios. As risk management focuses on the mitigation of cash flow and earnings volatility, the ratios derived from cash flow and earnings will also be less volatile.

Lower volatility in ratios and cash flows are perceived as positive by lenders. This means that lenders will subsequently lower the credit spreads and increase borrowing possibilities for the company.

3. Lowering the effective tax rate

The value of a company increases when the tax shield related to debt exceeds the cost of financial distress that is associated with debt. A combination of annual volatility in stock returns and leverage of the company determines the expected value of the tax shield.

High financial leverage and earnings volatility will lead to lower expected values of the tax shield. As a result, the shield produces fewer profits because of a loss in time value from loss carry forwards. With risk management, a company can influence and control the annual volatility of stock returns and this allows the company to increase the expected value of the tax shield.

The relationship between the WACC and taxes will be discussed in more detail in Part 7 of this guide.

4. Increasing optimal leverage

Professional risk management increases the shareholder value of the company: it lowers the credit spread and the cost of equity, and increases the expected relative tax shield. All these factors will result in an even larger benefit of risk management, which is the possibility of increasing the leverage of the company. The combination of lower required return on equity and a lower effective cost of debt can help to provide the option for a company to increase its leverage. As shown in the first two articles of this guide, increasing leverage to an optimal point creates shareholder value.

Trend in Risk Management

An integrated, proactive and quantitative approach to risk management is the latest trend in the financial markets. Increasingly, companies make use of systems to quantify the market risks their companies face and use this information for decision-making at a strategic level.

Most risk management today is aimed, primarily, at hedging transaction exposures. Few companies actively hedge interest rate exposure and FX translation exposure and an even smaller group of companies are also hedging their total economic exposure including, for example, commodity price risk.

In order to lower the earnings volatility, companies should focus on all the financial variables influencing the earnings and profitability of the company in the mid- to long-term. Useful methods to measure and manage those risks are cash-flow-at-risk or earningsat- risk models.

Current accounting rules (IAS 39 and FAS 133), however, motivate companies to pursue a risk management strategy that is primarily aimed at short-term earnings stability and makes it more difficult to hedge economic risks in order to minimize earnings volatility. If the economic hedges do not comply with hedge accounting standards then the fair value changes of the hedges are going through the P&L of the company, resulting in increased earnings volatility. This, of course, is quite the opposite of what a company engaged in risk management wants.

Committed Capital as an ART

Form As discussed in part one of this series, companies tend to maintain a sub-optimal WACC (left on the WACC curve) with a lower than optimal leverage.

A reason for this is that they want to prevent a situation of financial distress due to unforeseen events. To avoid this, companies maintain a higher than necessary credit rating and WACC in order to prevent themselves from moving towards the ‘right side’ of the optimum level.

When a company finds itself in a position of financial distress, it is relatively difficult to get back to the optimum level. Debt, as well as equity, will be more expensive and difficult to issue in this scenario.

Alternative risk transfer (ART) products can prove to be a useful instrument in optimizing the financial structure and WACC of a company whereby the abovementioned risk of financial distress is mitigated.

ART products enable companies to transfer risk in a non-traditional way by creating new possibilities to issue capital when pre-determined events occur.

An example of an ART product is committed capital, which is an option purchased by a company to issue capital, either debt or equity, if a pre-determined outside event occurs.

Take, for example, a manufacturing company that is exposed to high fuel prices. The increased fuel price cannot be set off by its clients so the increasing prices have a direct impact on the earnings, and indirectly on the equity of the company. To avoid the possible resulting financial distress, the company can buy an option (the committed capital product) to issue equity at pre-determined prices when average fuel prices are above a defined trigger level during a certain period. By issuing the equity, the company can restore the required WACC and credit rating and prevent financial distress.

Committed capital usually involves the payment of a fee (option premium) to the capital supplier from the company seeking capital in exchange for which the capital supplier agrees to supply paid-in capital on fixed terms based on a date in the future. Committed capital is therefore a form of contingent capital with an option on paid-in capital. Because of this optional characteristic of the instrument, contingent capital can in some cases have the advantage of being an off-balance sheet type of capital.

Like all sorts of capital, committed capital comes at a cost. The cost and benefits of the product have to be carefully examined and taken into account when evaluating a move into this type of financing. When conditions are right, committed capital will have a positive effect on the company by lowering the WACC. With the developments in ART products, there is convergence in capital and risk management products.

Conclusion

Corporate risk management has a positive impact on shareholder value, which can generally be increased by reducing the WACC and/or by enlarging expected cash flows. We have seen in this article how risk management can help a company to lower their WACC by lowering the cost of equity, lowering the cost of debt, increasing the expected tax shield and unlocking the possibility for a company to increase its leverage with debt.

Furthermore, accounting regulation can motivate a company not to hedge, even though this would be desirable from an economic point of view. Finally, committed capital as a form of ART products was highlighted as an instrument for a company to increase its leverage without running the risk of moving towards the undesirable ‘right side’ of the WACC curve.

In business, success and failure are never far apart. Among the many different options available, management has to select those initiatives that can be managed with (limited) corporate resources in terms of capital, people and time available. The aim of the game is to maximize shareholder or stakeholder value.

Estimating the potential for the creation of shareholder value or economic ‘value add’ of a project is not rocket science. Any project with a positive net present value (NPV), where the cash flow is discounted at the weighted average cost of capital (WACC), should increase shareholder or economic value. However, experienced business managers know that in reality this is not that easy.

Management has always tried to include some objectivity in project selection in order to avoid personal risk. There are a wide range of methods and models for calculating and ranking the NPVs of projects under review, but most models are a variation on discounted cash flow or real option methods. While many of these are complex and cumbersome to use, if not ineffective in day-to-day business, others in contrast are far too simple.

The model selected will affect the estimated shareholder value created as well as the ranking of projects. Without careful examination, a model or method could provide a false objective measure to determine the value created. This is not because the formulae are incorrect, but because the input assumptions applied by the analyst are often taken for granted and not properly understood.

This article examines to what extent input, assumptions and models used for project selection could create a biased opinion of the creation of shareholder value. Companies should also make sure that the investment proposals allow management to compare individual projects and select those that make the best contribution to the creation of shareholder value. Treasury, as a custodian of risk management, could be the internal consultant to management in preparing and substantiating decisions on the allocation of a company’s limited resources.

Scope of Projects

Projects are different from business operations because they require a team of (hand-picked) people to achieve pre-defined objectives within an agreed timeframe, as well as an (upfront) agreed investment.

Once the objectives are achieved and the output is handed back to the business, the project and its organization is dissolved.

Typically, projects are created to improve or expand business operations but the nature and effect of a project can vary widely. For instance, a project on the acquisition and integration of new business is different to a project to develop and introduce a new product. A calculation of the shareholder value created can, of course, help to prioritize all these projects but because the effort, scope and risk of each project are different, companies must make sure they make accurate and meaningful comparisons between projects.

1. Cash flow projections

Each model starts with a forecast of project cash inflow and outflow. By its very nature, the validity of a forecast is highly dependent on the underlying assumptions, and most models recognize that cash flow projections cannot be 100% accurate.

More complex models include a sensitivity testing function but this takes considerable effort to build.

Many companies take shortcuts by varying the net or gross cash flows as calculated for the base case. These shortcuts might give an inaccurate view because varying the value of (net) cash flow does not recognize the fact that delayed projects could incur not only higher cost but also costs over a prolonged period. As a result, revenues could be lower than anticipated or the expected cash inflows from that project may be delayed. In fact, any delay to the anticipated cash inflow can have a disproportionate effect on the NPV of the project.

A second issue related to cash flow projection is what elements should be included. Some companies include only ‘hard dollar savings’, ignoring ‘soft dollar savings’, such as unlocking partial full-time equivalents (FTEs) allowing staff to focus on (other) value adding activity, or existing cash flow that might be jeopardized if the project is not accepted.

Other benefits, such as security, market perception or quality of data, are even more difficult – if not impossible – to quantify. And, even if they were, it would still be difficult to quantify their contribution to individual projects.

The more companies focus on ‘hard dollar savings’, the more projects will need to focus on core business operations. As a result, projects that would significantly improve the quality of management information systems without reducing headcount might be overlooked. Short and low risk projects with a small upfront investment will be considered a higher priority than larger, more risky projects. For instance, projects building on existing infrastructure to create incremental benefits will typically be favoured above projects that result in a paradigm shift within the organisation.

A third issue is the horizon of the cash flow projection.

For comparison purposes, companies often have standard projection horizons of three or five years. However, the longer the project implementation takes, the longer it will take for the benefit to materialize.

Prefixed horizons favour projects with ‘quick wins’, low investments and short implementation. Important infrastructure projects might not return a significant positive NPV over a three-year period. On the other hand, projects with lasting ‘quick wins’ contribute a benefit after three, four or even 10 years – long after anybody would even remember the objectives!

If one sets the horizon of projections in a different way for each project, comparing the projects will not be straightforward. If one assumes that projects are considered only to the extent that they enhance shareholder or stakeholder value, the relevant horizon should be adjusted to the profile of stakeholders.

2. Discount factor

After the projections have been validated, the next step is to discount cash flows in order to make the NPV comparable. In theory, the WACC represents the rate at which projects will start generating shareholder value. The WACC is the weighted average cost of capital though and if a company is treated as a portfolio of projects, the WACC is a reflection of all activities and risks inherent in the company’s businesses.

Furthermore, the WACC is not constant over time. Among other factors, the WACC depends on the risk free rate, the company’s funding strategy (leverage) and risk profile. Each of these factors will change over time and can be different for each business line or project. The cost of capital should therefore be agreed individually for each project, and there are a number of issues that need attention.

Allocation of equity and debt

The allocation of equity and additional funding to projects is an important factor for the calculated NPV.
Using the current WACC for the calculation disregards the effect a project might have on company leverage when approved. Using the current WACC will also underestimate the shareholder value created by the project if additional (senior) funding is put in place.

However, in a similar case, the marginal approach to the project cost of capital would allocate all new (senior) funding disproportionately to the new project and thus overestimate the shareholder value to be created.

Another approach to this issue is to estimate the risk profile of an individual project and allocate equity accordingly. Depending on the magnitude and profile of projects in the portfolio, this might imply that a company could have a temporary or permanent equity surplus (or shortage). All projects should then compensate for this difference in order to satisfy stakeholders’ requirements.

A project cost of capital curve

The WACC will change over time as a result of market fluctuations and funding strategies. It is therefore not unreasonable to discount the first year cash flow at a different rate than that of the fourth or fifth year. The curve for the cost of capital for an individual project does not have to correlate to a risk-free yield curve.

The leverage strategy and change in the company’s risk profile will also affect this curve.

3. Identifying project risk

Each project will have a specific risk profile. The real option method tries to treat each risk component as a decision ‘option’ and estimates the value of each one using standard option calculation methods. The result of this approach to project risk is dependent on the predicted accuracy of the decisions, likelihood of each option available and timing of such occasions.

The more options involved in each decision, the more difficult it will be to verify the assumptions and thus validate the outcome.

Other simpler and widely used models will increase the discount factor with a risk premium. This approach will not favour projects with a high upfront investment and long impact horizon. Outsourcing projects that convert fixed investments into variable cost might also benefit disproportionately from this approach to project selection.

Risk is project specific and sometimes even option specific, i.e. two alternative approaches to the same project might have different risk profiles. The case for outsourcing a project to two different countries might have an identical cash flow; however, the market might see one as a higher risk than the other (e.g. as a result of additional country risk). Allocating additional equity to one project or adjusting the company WACC with a country specific outlook are alternative approaches for incorporation of such risk elements.

Individual projects can potentially affect the overall company risk profile. Acquisitions or major investments could affect the company beta and change the overall cost of capital. If these changes are not incorporated in the project NPV, the contribution to shareholder value can easily be misjudged. A marginal approach to allocating the cost (or benefit) of changing the company risk profile is tempting, especially when companies execute a diversification strategy. However, quite a few companies do feel the pressure of trying to capitalize on a break-up premium.

To address the element of risk, some methods will use a less complex approach by increasing the standard project discount factor. This risk factor might vary from project to project and this approach to risk favours projects with ‘quick wins’ early on in the project. This can be at the expense of projects with long-term structural impact because of the reduced NPV of cash flows over a long period of time. For the same reason, the method also favours projects with small upfront investments.

A Role for Treasury

In order to substantiate and motivate the value created by projects, companies need to ensure that cash flow projections and project risk are modelled in such a way that the outcome is comparable. Project support offices (if available) are hardly ever equipped for this task.

Treasury as the custodian of cash forecasting, risk management and fair value calculation, is ideal for this job. It would make perfect sense for treasury to develop useful models for project managers and evaluate the business case documents for executive management. In this way, treasury would be able to reinforce its role as an internal consultant on cash flow and risk management.

Conclusion

Many companies put a lot of effort into modelling the benefits of projects prior to approval. Allocating scarce resources in order to ensure a successful project is an important responsibility of management and they should understand how an adopted model is applied within a project.

Validating the motivation behind input and stress testing of cash flow projections is probably more important than the fact that, on paper, projects will return the value that makes them eligible for approval. Treasury can use its expertise to assist management and make sure the company chooses the best projects.

It is important to look beyond mere numbers and not focus on the difference of 1% or 2% in the NPV; remember there is always an element of art and ‘gut instinct’ in project selection. Management should therefore treat project analysis as a tool to support their strategic decision-making within the company.

Overview of WACC Estimation

The WACC is recognized as one of the most critical parameters in strategic decision-making. It is relevant for business valuation, capital budgeting, feasibility studies and corporate finance decisions. When estimating the WACC for a company, there is a clear trade-off between theoretical purity and actual circumstances faced by a company. The decision in this context should reflect the actual environment in which a company operates. In general, the WACC is estimated using the following equation:

D: Market value of interest-bearing debt
E: Market value of common equity
H: Market value of hybrid capital
R_D: Cost of interest-bearing debt
R_E: Cost of common equity
R_H: Cost of hybrid capital
Ô: Corporate tax rate

The estimation of the WACC is based on several key assumptions:

• It is market driven. It is the expected rate of return that the market requires to commit capital to an investment.
• It is a function of the investment, not the investor.
• It is forward looking, based on expected returns.
• The base against which the WACC is measured is market value, not book value.
• It is usually measured in nominal terms, which includes expected inflation.
• It is the link, called a discount rate, which equates expected future returns for the life of the investment with the present value of the investment at a given date.

The WACC seems easier to estimate than it really is. Just as two people will rarely interpret a piece of art the same way, neither will two people calculate the same WACC. Even if two people do reach the same WACC, all the other applied judgments and valuation methods are likely to ensure that each has a different opinion regarding the components that comprise the company value.

Therefore, the following sections of this article will discuss the different WACC components in more detail. Errors that are frequently encountered in practice will be highlighted as well as best market practice as a guide for estimating the WACC.

Capital Structure

The first step in developing an estimate of the WACC is to determine the capital structure for the company or project that is being valued. This provides the market value weights for the WACC formula. Best market practice is to define a target capital structure and this is for several reasons.

First, the current capital structure may not reflect the capital structure that is expected to prevail over the life of the business.

The second reason for using a target capital structure is that it solves the potential problem of circularity involved in estimating the WACC, which arises when calculating the WACC for private companies. For instance, we need to know market value weights to determine the WACC but we cannot know the market value weights without knowing what the market value is in the first place.

To develop a target capital structure, a combination of three approaches is suggested:

1. Estimate the current capital structure.

A capital structure can comprise three categories of financing: interest-bearing debt, common equity and hybrid capital. The best approach for estimating the current ‘market value-based’ capital structure is to identify the values of the capital structure elements directly from their prices in the marketplace, if available. For equity, market prices are available for public companies, but it is more difficult to identify the market value of equity for private companies, business units and also for illiquid stocks.

The same applies for public debt, such as bonds, where the market value can be identified from available market prices. In the case of private debt, however, such as bank loans and private placements, the current value needs to be calculated. (For discussion about the difficulties of calculating the market value of hybrid capital, please refer to the third article in this series on the WACC.) The conclusion is that estimating the current capital structure based on market values could be difficult when market prices are not available. The next approach could assist in solving this difficulty, by estimating a target capital structure based on information from comparable companies.

2. Review the capital structure of comparable companies.

In addition to estimating the market value-based capital structure currently and over time, it is useful to review the capital structures of comparable companies as well.

There are two reasons for this. First, comparing the capital structure of the company with those of similar companies will help to understand if the current estimate of the capital structure is unusual. It is perfectly acceptable that the company’s capital structure is different, but it is important to understand the reasons behind this.

The second reason is a more practical one because in some cases it is not possible to estimate the current financing mix for the company. For privately held companies, a market-based estimate of the current value of equity is not available.

3. Review senior management’s approach to financing.

It is important to discuss the company’s capital structure policy with senior management to determine their explicit or implicit target capital structure for the company and its businesses.

This discussion could give an explanation why a company’s capital structure may be different from comparable companies. For instance, is the company by philosophy more aggressive or innovative in the use of debt financing? Or is the current capital structure only a temporary deviation from a more conservative target?

Often companies finance acquisitions with debt they plan to amortize rapidly or refinance with equity in the near future. Alternatively, there could be a difference in the company’s cash flow or asset intensity, which results in a target capital structure that is fundamentally different from comparable companies.

Corporate Tax Rate

The WACC is a calculation of the ‘after tax’ cost of capital. The tax treatment for the different capital components – such as interest-bearing debt, common equity and hybrid capital – is different. The corporate tax rate in the earlier mentioned WACC equation is applicable to debt financing because in most countries interest expense on debt is a tax-deductible expense to a company.

It is appropriate, however, to take into consideration the fact that several countries apply thin capitalization rules that may limit tax deductibility of interest expenses to a maximum leverage.

Furthermore, in some countries, expenses on hybrid capital could be tax deductible as well. In that case the corporate tax rate should also be applied to hybrid financing and the WACC equation should be changed accordingly. (For more information on hybrid capital please refer to the third article of this series on the WACC.)

Finally, corporate tax can also have a positive impact on the cost of equity. An example is Belgium, which recently introduced a system of notional interest deduction, providing a tax deduction for the cost of equity. This system will be further explained in the fifth article of this series, which elaborates on the impact of notional interest deduction on the WACC. In other words, the calculation of the WACC for Belgian financing structures needs to be revised.

The main conclusion is that the application of the corporate tax rate in the WACC equation will differ per country. As mentioned before, when estimating the WACC for a company, there is a clear trade-off between theoretical purity and actual circumstances faced by the company. Best market practice is to reflect the actual environment in which a company operates. Therefore the WACC equation needs to be revised accordingly.

Cost of Interest-bearing Debt

The cost of interest-bearing debt can be estimated using the following equation:

R_D = R_F + DRP

R_D: Cost of interest-bearing debt
R_F: Risk-free rate
DRP: Debt risk premium

The category of interest-bearing debt consists of short-term debt, long-term debt and leases. Many companies have floating-rate debt, as an original issue or artificially created by interest rate derivatives. If floating-rate debt has no cap or floor, then it is best market practice to use the long-term debt interest rate. This is because the short-term rate will be rolled over and the geometric average of the expected short-term rates is equal to the long-term rate.

The cost of debt is calculated using the marginal cost of debt, i.e. the cost the company would incur for additional borrowing, or refinancing its existing interest-bearing debt. This cost is a combination of the risk-free rate and a debt risk premium. Credit ratings are the primary determinants of the debt risk premium. (More information on the relationship between the WACC, shareholder value and credit ratings can be read in the second article of this series on the WACC.)

The risk-free rate is the theoretical rate of return attributed to an investment with zero risk. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a specified period of time. In theory, the risk-free rate is the minimum return an investor should expect for any investment.

In practice, however, the risk-free rate does not technically exist, since even the safest investments carry a very small amount of risk. Therefore best market practice for WACC estimations is to use the yield on a 10-year government bond as a proxy for the risk-free rate.

Estimating the WACC can be a challenging exercise, however, because a risk-free government bond is not always available in emerging markets. (This will be discussed further in article seven of this series.)

The cost of debt is the yield-to-maturity on publicly traded bonds of the company. Failing availability of that, the rates of interest charged by banks on recent loans to the company would also serve as a good cost of debt. When using yield-to-maturity to estimate the cost of debt it is important to make a distinction between investment and non-investment grade debt. Investment grade debt has a credit rating greater than or equal to BBB- (Standard & Poor’s). For investment grade debt, the risk of bankruptcy is relatively low.

Therefore, yield-to-maturity is usually a reasonable estimate of the opportunity cost. The coupon rate, which is the historical cost of debt, is irrelevant for determining the current cost of debt. Best market practice is to use the most current market rate on debt of equivalent risk. A reasonable proxy for the risk of debt is a credit rating.

When dealing with debt that is less than investment grade, pay attention to the difference between the expected yield-to-maturity and the promised yield-to-maturity. The latter assumes that all payments (coupon and principal) will be made as promised by the issuer. Therefore it is necessary to compute the expected yield-to-maturity, not the quoted, promised yield. This can be done based on the current market price of a low-grade bond and estimates of its expected default rate and value in default.

If the necessary data is not available, use the yield-to-maturity of BBB-rated debt, which reduces most of the effects of the differences between promised and expected yields.
Leases, both capital and operating, are substitutes for other types of debt. In many cases it is reasonable to assume that their opportunity cost is the same as for the company’s other long-term debt. Since capital leases are already shown as debt on the balance sheet, their market value can be estimated just like other debt.

Operating leases should also be treated like other forms of debt. As a practical matter, if operating leases are not significant, it could be decided not to treat them as debt. They can be left out of the capital structure and the lease payments could be treated as an operating cost.

Cost of Common Equity

For estimating the opportunity cost of common equity, best market practice is to use the expanded version of the capital asset pricing model (CAPM). The equation for the cost of equity is as follows:

RE = RF + [βL * MRP] + SRP

RE: Cost of common equity
RF: Risk-free rate
βL: Levered beta of equity
MRP: Market risk premium
SRP: Specific risk premium

The market risk premium is the extra return that the stock market provides over the risk-free rate to compensate for market risk. The estimate of the historically derived market risk premium is about 5 per cent. This estimate depends on how much history is used. Structural changes in the economy and markets, however, suggest that more recent data provides a better basis for predicting the future. Therefore, best market practice is to use data from the second half of the last century. This is a sufficiently long period to achieve statistical reliability, while avoiding the potentially less relevant market returns.

The historically derived market risk premium can be benchmarked against the implied market risk premium of today’s market capitalization and earnings. This can be done under different assumptions for future earnings growth and reinvestment. Recent studies show an implied market risk premium of 5-5.5 per cent, which is comparable to the historical derived estimate.

Beta is the measurement for the systematic risk of a company and is typically the regression coefficient between historical dividend-adjusted stock returns and market returns. For decades, investors were only concerned with one factor, beta, in their portfolio selection. Beta was considered to explain most of a portfolio’s return.

This one-factor model, otherwise known as standard CAPM, implies that there is a linear relationship between a company’s expected return and its corresponding beta. Beta is not the only determinant of stock returns though so CAPM has been expanded to include two other key risk factors that together better explain stock performance: market capitalization and book-to-market (BtM) value.

Recent empirical studies indicate that three risk factors – market (beta), size (market capitalization) and price (BtM value) – explain 96 per cent of historical equity performance. These three-factor models go further than CAPM to include the fact that two particular types of stocks outperform markets on a regular basis: small caps and value stocks (high BtM value).

The approach to estimate beta depends on whether the company’s equity is traded or not. Therefore the beta of a company can be estimated in two ways. The first and preferred solution for public companies is to use direct estimation, based on historical returns for the company in question.

The second way is to use indirect estimation. This solution is mainly applicable to business units and private companies, but also for illiquid stocks or public companies with very little useful historical data. This estimation is based on betas from comparable companies, which are used to construct an industry beta. When constructing the industry beta, it is important to ‘unlever’ the company betas and then apply the leverage of the specific company.

Best market practice is to incorporate a specific risk premium for small caps and value stocks when estimating the cost of equity. As mentioned earlier, this premium may be applicable to a specific company, based on its market capitalization and BtM value.

Cost of Hybrid Capital

Hybrids are financial instruments that combine certain elements of debt and equity, such as preferred equity, convertible bonds and subordinated debt. WACC estimations are complicated by the introduction of hybrid capital into the capital structure.

This is most easily resolved through an effective split of the instrument’s value into debt and equity to reflect the true debt-equity mix. (The fifth article of this series describes how issuing hybrids can optimize the WACC. The article outlines how hybrids are analyzed on their impact on shareholder value, but they are also analyzed from the perspective of treatment by accountants/IFRS and rating agencies.)

Conclusion

There are many ways to make errors both in estimating the WACC and applying it in practice and this article discussed the different WACC components in more detail. Attention was given to some of the errors frequently encountered in practice. Best market practice was provided as a guide for estimating the WACC while more practical guidance on estimation and application of the WACC will be discussed in the rest of the articles in this series.
Let’s return to the analogy at the beginning of this article. Is estimating the WACC comparable to interpreting a piece of art?

Again, just as two people will rarely interpret a piece of art the same way, neither will two people calculate the same WACC. The key message of this article is that both are based on assumptions before reaching a final estimation or interpretation.

The more time you spend on defining good assumptions for estimating the WACC, the better the quality of business valuation, capital budgeting and other financial decision-making will be. It is like discovering the real value of art; it all starts with a good interpretation.

The article describes the relationship between the WACC, shareholder value and the existence of an optimal credit rating.

Credit Rating Policy

Newton’s first law of motion states that objects ‘tend to keep on doing what they are doing’. In fact, it is the natural tendency of objects to resist changes in their state of motion. This resistance to change is also known as inertia. Many companies have the tendency to maximize their credit rating towards a triple-A rating in order to minimize their cost of debt.

Generally, however, this policy does not minimize the weighted average cost of capital (WACC). Therefore, these companies have the opportunity to stop this inertia and increase shareholder value as a result.

Market evidence shows that, in recent years, fewer companies have received a triple-A credit rating and there are several reasons for this:

• More tolerance of risk
• Company-specific challenges
• Mergers and acquisitions
• Regulatory concerns
• New industry dynamics

This article discusses the concept that the optimal credit rating for companies is not always the highest rating. Credit ratings give information about the probability of default and the size of loss when a company defaults (recovery ratio). Therefore a credit rating gives an indication about the downside risk of debt and not about the upside potential of equity. There is a great misunderstanding about the corporate’s objective with respect to credit ratings. The table below provides insight into the relationship between business risk, financial risk and credit ratings.

A triple-A credit rating might seem ideal but it actually indicates that a company bears relatively low risk. For a company that does not invest in highrisk projects, or for a company with low leverage, it is relatively easy to get a triple-A rating. Is this an indication of good performance? Not really, maybe a triple-A credit rating is the result of a lack of creativity.

Risk is inherent in running a company therefore the credit rating should not be a goal in itself but the result of the corporate objective to maximize value for shareholders and other stakeholders.

Corporate Finance Dilemma

For most companies, corporate finance is a tradeoff process between raising debt, common equity and hybrid capital. The availability of different types of capital creates a dilemma for these companies.

In general terms, debt is advantageous because of its low costs and tax deductibility but it can be disadvantageous where bankruptcy costs are concerned. More debt increases the default risk of a company and therefore shareholders will require a higher return on equity. Furthermore, a company can also raise hybrid capital, which contains elements of both debt and equity. But the impact of hybrids on the WACC and shareholder value differs, depending on the treatment by tax authorities, accountants and rating agencies. Ultimately, the optimal capital structure of a company will normally consist of a mixture of debt, common equity and hybrid capital.

Designing such a capital structure is based on a combination of two elements:

1. The level of debt-to-equity.
2. The mixture of financing instruments.

Optimal Level of Debt-to-Equity

Companies should focus on the optimal level of debt-to-equity, also known as leverage. Best market practice is to define a target capital structure and to combine this objective with maintaining sufficient financial flexibility to cope with adverse scenarios.

Companies with stable cash flows and low risk profiles can generally absorb more debt into their balance sheets than other types of companies. To define the optimal capital structure, however, an analysis is required that examines how the perceptions of investors, rating agencies and financial markets in general are affected by capital structure changes. In assessing an optimal capital structure it is important to focus not only on base case scenarios but also on downside scenarios, which means that an optimal capital structure will allow for unused borrowing capacity. This enables the corporate to increase debt in adverse circumstances, e.g. the possibility that capital expenditure may be substantially above base case scenarios. An example of unused borrowing capacity could be contingent capital, such as a standby credit facility.

The graph shows the progress of the WACC as well as the market value of a company. The flat bottom of the WACC graph clearly shows that there is a relatively large range where the level of debt to- equity is maximizing shareholder value. This indicates that the optimal credit rating of a company exists within this area. It is important to mention that every company has its own optimal range. The definition of an optimal credit rating is based on the following considerations:

1. Minimum WACC: The credit rating should not be a goal in itself, but the result of the corporate objective to maximize value for shareholders and other stakeholders. Therefore an optimal credit rating is located in the range where the level of debtto- equity minimizes the WACC. This is also displayed in the graph above.
2. Meeting financial covenants: Financial covenants provide creditors with a warning about deteriorating financial conditions and give them the ability to influence the borrower under these conditions. A number of companies have financial covenants to maintain investment grade status. It is likely that these covenants will increase the credit spread on debt when the credit rating is close to minimum investment grade.
3. Protection against adverse scenarios: An optimal credit rating will allow a company enough unused borrowing capacity so that during times of adversity it can use this capacity. In particular, it is important that financial projections under adverse scenarios remain consistent with investment grade status and hence continue to allow a company to finance its functions.
4. Protection against turbulent market conditions: Access to capital markets may be difficult during turbulent market conditions if companies are rated at BBB and below. Credit spreads typically widen under adverse economic conditions as investor quality consciousness and ‘flight to quality’ increase.

Maintenance of an optimal credit rating will reduce the risk that companies will be unable to attract necessary finance at reasonable rates.

Optimal Mixture of Financing Instruments

When the optimal level of debt-to-equity is defined, companies should focus on the optimal mixture of financing instruments, including:

1. Interest-bearing debt: When raising interestbearing debt, a company can generally choose between bank debt, private debt and public debt. Best market practice is to match cash flows on debt as closely as possible with cash flows that the company makes on its assets. By doing so, a company reduces default risk and it increases the debt capacity. Furthermore, it increases shareholder value because of lower earnings volatility.
2. Common equity: A popular statement is ‘equity is a cushion, debt is a sword’. While debt with its fixed payment character disciplines managers, equity should give them more flexibility because of the lack of a fixed return. However, stock markets can discipline managers as well. A good example is the recent trend of hostile takeovers of underperforming public companies by private equity firms.
3. Hybrid capital: Hybrids contain elements of debt and equity, e.g. preferred equity, convertible bonds and subordinated debt. The perfect hybrid instrument will have all of the tax advantages of debt, while preserving the flexibility offered by equity. A company must ensure that it has not crossed the line drawn by tax authorities though. It is a waste of effort if the instrument that is designed does not deliver the tax benefits intended.

The overall objective when designing the optimal mixture of financing instruments is to keep investors, rating agencies and financial markets satisfied. Bondholders and ratings agencies want companies to issue equity because it makes them safer. Shareholders do not want companies to issue more equity because it dilutes earnings per share.

Financial covenants ensure that companies meet their requirements in terms of capital ratios, usually defined in book value. Financing that leaves all stakeholders happy is the ultimate goal.

Best market practice is not to lock in market ‘mistakes’ that work against a company. For example, rating agencies could under-rate a company (credit rating gap), or financial markets could under-price stocks or bonds (value gap). If this occurs, companies should not lock in these gaps by issuing financing instruments for the long-term. In particular, when equity is underpriced, issuing equity or equity-based products (including convertibles) would transfer wealth from existing to new shareholders.

Furthermore, issuing long-term debt when a company is under-rated locks in interest rates at levels that are too high, given the actual default risk. Therefore solving potential gaps requires good communication with investors or rating agencies. This can be done based on in-depth financial analysis that examines how the perceptions of investors, rating agencies and financial markets in general are affected by capital structure changes.

In assessing a capital structure it is important to focus not only on base case scenarios but also on downside scenarios.

Corporate Case Studies on Capital Structure and Credit Rating

The following section contains case studies on the policy of two companies, KPN Telecom and Nestlé, with respect to their capital structure and credit rating.

KPN Telecom: Series of Downgradings

Highly leveraged companies could face a series of downgradings. A good example is the situation that occurred several years ago with the Dutch listed company, KPN Telecom. The telecoms market was bullish for a long time but expectations had started to diminish. It was doubtful whether the expected growth could be realized or whether the high capital expenditures for UMTS (the 3G mobile system) could provide a profitable return.

Rating agencies, such as Standard & Poor’s and Moody’s, picked up on this market signal and downgraded several telecom companies and, as a consequence, the interest expenses of those companies increased. The highly leveraged companies, such as KPN Telecom, directly faced financial problems and therefore rating agencies further downgraded these companies. The interest expenses further increased and so did the financial problems.

In just three years, KPN Telecom was downgraded several times. From AA in September 2000, its rating reached the lowest level of BBB- at the end of 2002. This was also the end of the series of downgradings. From September 2002, KPN Telecom was able to improve its credit rating from BBB- to A- by reducing its debt level and by divesting noncore activities.

At the beginning of February 2006, it decided to increase its leverage again because it felt the pressure of a potential hostile take over by a group of private equity firms. In this group’s opinion, KPN Telecom was too conservatively financed. The additional debt that was raised would be used to finance share repurchases and potential acquisitions.

After the announcement of increasing leverage, KPN Telecom was immediately downgraded from A- to BBB+. Shareholders did reward the revised financing policy with an increase of the stock price by 6.4 per cent though.

Nestlé: Highest or Optimal Credit Rating?

In September 2005, Swiss company Nestlé considered whether it should go for the highest or optimal credit rating. The triple-A rated company, therefore, performed an analysis of its capital structure and concluded that the WACC could be decreased from 7.6 to 7.4 per cent by changing the level of debt-toequity from 10 towards 30 to 35 per cent.1 However, Nestlé decided not to change its capital structure and it is interesting to find out what influenced this decision.

One of the main reasons Nestlé gave was that with a triple-A rating debt can be raised on better terms and conditions. Furthermore, Nestlé wanted to maintain maximum financial flexibility for potential acquisitions. Of course, the cost of debt is lower with a triple-A rating, however, in this situation it is likely that the company does not optimally benefit from the tax deductibility of debt financing. It is also likely that some interesting investment projects would be declined because of a too low risk tolerance.

Nestlé chose not to change its credit rating policy, although it acknowledged the potential benefits of a lower, optimal credit rating. These potential benefits can be quantified. Nestlé could add about €1.5bn shareholder value if it further optimize its capital structure.2 This can be assumed as its accepted costs for maintaining maximum financial flexibility.

Roadmap to an Optimal Credit Rating

The roadmap to an optimal capital structure and credit rating can be defined as follows:

1. Start with a scenario analysis of the cash flows through an intuitive or quantitative approach. Intuitively, by analyzing the growth potential of a company, the cyclicality of the cash flows and specific factors that determine the cash flows. For companies with substantial operating history, it can be quantified how sensitive company value and operating income have been to changes in macroeconomic variables, such as inflation, interest rates and exchange rates.
2. Best market practice is to define a target capital structure and to combine this objective with maintaining sufficient financial flexibility to cope with adverse scenarios. When the optimal level of debt-to-equity is defined, companies should focus on the optimal mixture of financing instruments, including debt, equity and hybrid capital.
3. The optimal capital structure and credit rating is achieved when the WACC is minimized. However, it is relevant to combine this objective with meeting financial covenants and by protecting against adverse scenarios and turbulent market conditions.

Companies located at the right side of the optimal range should be focusing on reducing their debt position and therefore avoiding a series of downgradings. For example, KPN Telecom mainly improved its credit rating from BBB- to A- by reducing its debt level and by divesting non-core activities.

Companies located at the left side of the optimal range could increase their leverage by raising more debt or reducing their equity position. The latter can be realized with share repurchases or distribution of super dividends. Furthermore, these companies could reduce the WACC by investing in more risky projects that add shareholder value.

The highest possible credit rating is not always the best option. Maximizing value for shareholders and other stakeholders can be realized with an optimal level of debt-to-equity, including a mixture of debt, common equity and hybrid capital. As a result, the credit rating will be optimal.

Conclusion

This article has elaborated on the relationship between the WACC, shareholder value and credit ratings. Some companies may have valid reasons to choose a triple-A rating. Nestlé, for example, has clearly thought about the issue and has chosen a sub-optimal WACC. It is important, however, that companies understand and think about the tradeoff between the WACC, shareholder value and credit ratings. In that way, a rational decision can be made about the optimal capital structure of a company.

This decision should be made with an open mind with regard to changes in the capital structure. If there is any irrational resistance to change, then it’s time for the company to end this inertia.

¹ Focusing on the drivers of value, www.ir.nestle.com
² This calculation is based on an operational cash flow of €4.3bn in 2004.