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Final Version FTA Final Presentation Webinar #2 17 July 2018

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Final Version FTA Final Presentation Webinar #2 17 July 2018 APPLIED FINANCE CENTRE Fac ulty of B us ines s and E conom ics FTA Webinar Weighted Average Cost of Capital: Part 2 17 July, 2018 Presented by: To n y C ar l t o n Associate Professor & Program Director, Corporate Finance Macquarie Applied Finance Centre APPLIED FINANCE CENTRE 1 Tony Carlton Applied Finance Centre, Macquarie University Associate Professor & Program Director, Corporate Finance To n y is responsible for managing the Corporate Finance stream in the prestigious Master of Applied Finance. Prior to joining the Applied Finance Centre To n y had over 25 years' experience in the manufacturing, resource and agricultural industries. His experience includes all aspects of corporate finance and strategy, including project evaluation, strategic portfolio analysis and restructuring, and the development and execution of growth strategies. He managed a number of large acquisitions and divestments both in Australia and overseas, and a number of large scale balance sheet restructurings. In the Masters of Applied Financ e program, To n y presents the Core Corporate Finance course, and elective subjects including Advanced Valuation, Managing Shareholder Value and Corporate Fin ancial Strategy. He completed his PhD at Macquarie University in 2015. APPLIED FINANCE CENTRE 2 1 Agenda Part 2 ü Recap of Part 1 q Challenges in applying WACC (continued) q WACC and Financial Strategy q Issues in estimating WACC q Sources of information for calculating WACC APPLIED FINANCE CENTRE 3 Recap of Part 1 WACC measures the returns required by investors in an asset q Used in Discounted Cash Flow (DCF) valuations q The WACC is determined by the characteristics of the cash flows being valued – primarily risk and debt capacity q Operating Free Cash Flows discounted at WACC to give Enterprise (or Asset) Value q Enterprise Value = Equity + Debt q When using WACC, Equity Value is determined as a Residual i.e. Equity = Enterprise Value – Debt APPLIED FINANCE CENTRE 4 2 Recap of Part 1 WACC measures the returns required by investors in an asset Where: Re is the Cost of Equity for the cash flows being valued; Rd is the Cost of Debt usually estimated as current borrowing rate; T is the marginal corporate tax rate, important because interest is tax deductible and equity is not. This means that, for sensible debt levels, WACC reduces due to tax benefit of interest deductions; D/V is the target debt capacity of the cash flows being valued,, where D is Debt is expressed as percentage of Enterprise Value, V. Target gearing is expressed in market value terms APPLIED FINANCE CENTRE 5 Recap of Part 1 Cost of Equity is key input into WACC calculation Cost of equity is estimated using the Capital Asset Pricing Model Re = Rf + β x MRP Where: Re is the Cost Of Equity: return required by shareholders allowing for the riskiness of the project; Rf is the Risk Free Rate: usually estimated as current long term government bond yield, ideally to match the term of the investment. is the investment’s Beta. It measures the sensitivity of an investment’s returns to changes in the overall market, and is a measure of relative risk. An asset with the same risk as the market has a Beta of 1. This is the risk that cannot be eliminated by diversification; MRP is the Market Risk Premium, an estimate of the additional returns that investors require to invest in the overall market compared to investing in risk free assets (which have a Beta of zero). In Australia, an MRP of 6% is most commonly used. APPLIED FINANCE CENTRE 6 3 Recap of Part 1 Sample Calculation: WACC for NewCrest Input Data Weighted Input to WACC Target Gearing 11% Cost of Debt x 6% x (1 – 0.30) 4.20% 4.20% x 11% 0.46% (1 – Tax rate) Cost of Equity 3% + 0.73 x 7.75% 7.75% x 89% 6.90% 6.5% WACC 7.36% APPLIED FINANCE CENTRE 7 Recap of Part 1 WACC based valuations used in wide range of applications Application Which means How used Capital Allocation Equity Valuation Impairment Testing Performance measurement Regulatory Pricing APPLIED FINANCE CENTRE 8 4 Recap of Part 1 Company wide v divisional cost of capital Company Wide Cost Divisional Cost of Capital of Capital Company wide cost of WACC calculated for each division or capital applied to all project based, on the Beta and D/V of projects the relevant division – valuations done using the divisional cost of capital Beta of parent Beta of each division usually found by company isused to using ‘comparable’ or ‘pure plays’ – calculate WACC for listed companies similar to each division company are used to estimate WACC, as if each division was a separate listed entity APPLIED FINANCE CENTRE 9 Recap of Part 1 Company wide hurdle leads to decline in quality of portfolio High High risk poor quality projects that Risk adjusted A get accepted Rate Return Company wide Low risk good WACC quality projects that get rejected Company wide WACC B does not adjust for risk of different assets 0 High Project Beta APPLIED FINANCE CENTRE 10 5 Recap of Part 1 Company wide v divisional cost of capital - example Calculate the cost of capital for a prospective investment in the aquaculture industry. Assume this investment has a target [Debt/Value] ratio of 10%; Step: Result [1] Find comparables Three good comparables in Australia: Tas s al , Huon and Clean Seas [2] Calculate the ‘Ungeared’ or Asset Beta is 0.59 - refer next slide #1. This is ‘As s et ’ B et a the systematic risk of the asset with zero debt [3] Calculate the “Geared’ or Regeared Beta is 0.63 - refer following slide #2. ‘equity’ Beta, uisng the target This is an Equity Beta with Debt/Value Ratio gearing equal to 10% [Note: D/E = 10/90] [4] Calculate WACC of Target Asset WACC is 6.80% - refer following slide #2 APPLIED FINANCE CENTRE 11 Agenda Part 2 q Recap of Part 1 ü Challenges in applying WACC (continued) q WACC and Financial Strategy q Issues in estimating WACC q Sources of information for calculating WACC APPLIED FINANCE CENTRE 12 6 Challenges in applying WACC (continued) Key issues in using WACC to support decision making #1: Company wide versus divisional cost of capital #2: Cost of capital and hurdle rates #3: Cost of Capital and risk #4: Post tax and pre tax WACC APPLIED FINANCE CENTRE 13 FIRMS’ INVESTMENT DECISIONS AND INTEREST RATES of years it would take for the capital outlay to be These observations are broadly in line with recent returned by the cash flows generated by the project. evidence from the Deloitte CFO Survey, which found Although the payback period is intuitive and easy to that nearly 90 per cent of the Australian corporations communicate, it does not take into account the time that responded used hurdle rates exceeding 10 per value of money and ignores cash flows beyond the cent, and around half of the corporations used a chosen cut-off date. hurdle rate exceeding 13 per cent (Deloitte 2014; Graph 3). Liaison contacts reason that the hurdle Evidence from Australian Firms rate is often set above the cost of capital to account for uncertainty about the cash flow projections. A typical firm in the Bank’s liaison program evaluates Challenges in applying WACC: Contacts also note that there #2 is likely to be an discretionary capital expenditure by using DCF optimism bias in these cash flow projections. As a analysis, and also by considering the payback period result, setting a hurdle rate above the cost of capital as a supporting consideration. This is in line with RBA survey (2015) and Deloittes (2014) find that nearly is likely to improve the chances that investments add the evidence from other advanced economies such 90% of companies use hurdle rates above 10value to the firm on a risk-adjusted basis.4 % as the United States and the United Kingdom (see below) and is also in line with earlier survey evidence Graph 3 for Australia. For instance, a survey of Australian firms Hurdle Rates conducted by academics in 2004 also found that the For investment decisions, share of firms* % % vast majority of firms used both methods, which, according to other surveys, had become more 40 40 popular over the preceding decades (Graph 2). Graph 2 30 30 20 20 10 10 0 0 0<7 7<10 10<13 13<16 !16 Hurdle rates – % * Excluding firms that do not use a hurdle rate Sources: Deloitte CFO Survey; RBA Many liaison contacts also report that hurdle rates APPLIED FINANCE CENTRE 14 are not changed very often and in some instances have not been altered for at least several years. These observations are also reflected in the recent survey by Deloitte; two-thirds of corporations indicated Discounted cash flow analysis their hurdle rate was updated less frequently than their formal review of the WACC, and nearly half Liaison contacts indicate that the hurdle rates used reported the level of their hurdle rate was changed to evaluate business investment opportunities are ‘very rarely’ (Graph 4). For these firms, changes in often several percentage points above the WACC. Hurdle rates of around 15 per cent are quite common, 4 Adjusting for risk by using a higher discount rate rather than by though the range of rates reported is relatively wide, probability weighting the cash flows introduces a bias against 7 longer-term projects, since the present value of a longer-dated cash from a little less than 10 per cent up to 30 per cent. flow is more sensitive to changes in the discount rate.
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