Tuesday, March 06, 2007

Deconstructing WACC

"Business School is WACC!" Google that in quotes. Looks like this catchy Urban Outfitter-like jingle has never been used before in the capitalist history of the world. You heard it here first. I would TM it, but it doesn't really identify a product or service offered by Rob & Rachel Co.

What is WACC (weighted average cost of capital), how do you calculate it? You may not care, but it is sort of interesting. It's a great way to impress potential employers if they ever cared to ask how one values something. In short, to determine the value of something that makes money (like a rental property, a baseball player, a dump truck, or a company), simply add up the cash you expect to get. Then divide the cash by a small amount. That's the value. Why divide? Time value of money. For example, if inflation stayed a constant 3% for the next couple of decades, then $1M in 2020 would be worth $681K today. You have to divide future cash by something. In the world of valuing companies (or anything with a debt and equity component), we use an
average of the cost of debt and cost of equity - hence WACC:

equity/(equity+debt)]*cost of equity + [debt/(debt+equity)]*cost of debt*(1-tax rate)

Here's the step by step on how to calculate from scratch:
  1. Equity, debt & tax rate = available and easy to find. Equity & debt are in actual dollars, tax is a percentage.
  2. Cost of Debt = percentage of what you're paying for your debt / loans. If it's a home, what is your loan interest rate? If it's a company, how much are you paying for your debt? This is super easy, found in the 10K or easily calculated by taking interest expense divided by debt. It's usually less than cost of equity.
  3. Cost of Equity = A fluffy but important (percentage) measure of how much equity-holders (investors) expect to be compensated for gracing you with their money. If you search the textbooks, you'll get a doctoral thesis on whether or not humanity can accurately measure cost of equity. Never mind the fluff. Use the CAPM method of calculating cost of equity: Rf + Beta*(Rm - Rf)
  • Rf = Risk Free Rate. Basically Rf = interest rate for treasury bills. Granted, in 50 years when China dumps our bonds on the world market, our t-bills won't be quite so risk free.
  • Rm = Market Risk. Use whatever you think is a good representative market for that which you're valuing. If it's a company - use an appropriate benchmark like S&P 500 (if you're valuing a big company), NASDAQ (if valuing a tech company), or Fidelity Aggressive International Fund (if valuing a small Romanian toy company).
  • Beta = measure of risk for your firm. Obtain from Yahoo! Finance, or calculate it yourself - it's very fun!
    • Download onto Excel the daily returns for your firm & the daily returns of an appropriate market benchmark.
    • Calculate the daily percentage change for each
    • Beta = Covariance (% changes for firm & % changes for benchmark) / Variance (% changes for benchmark).
I proudly admit that knowing how to decompose WACC sealed me an internship last summer (even though, ironically, Intel discounts at 15% for everything).

1 comment:

Dad said...