Merrill Lynch - Assessing Cost of Capital and Performance 2015

Corporate Finance Topics | Issue No. 1 2015

The WACC Hurdle:Assessing Cost of Capital and Performance

This is not an equity research publication. Corporate Finance

Topics is a publication of Bank of America Merrill Lynch’s Corporate

Finance Group. We are committed to helping our clients create

shareholder value by delivering innovative, strategic solutions to

address their most complex financial needs. We deliver the power

of the firm to our clients through a team of experts who draw upon

the broad capabilities of our global, integrated platform.

The WACC Hurdle: Assessing Capital Cost and Performance

Corporate Finance Topics | Issue No. 1 2015 1

The value of a business is a function of the expected cash flows that result from

management deploying capital; however, this capital has a cost. Value is created

to the extent cash flows exceed the costs required to achieve them.

In our Q2 2013 piece,1 we identified a positive correlation between the change

in ROIC and total shareholder return (price return plus dividends) when looking

at the 2008-2012 period. We have re-examined this correlation using the S&P

500 constituents from 2010 to 2014. Based on our analysis, the same correlation

continues. As we look internationally, we also see a similar correlation when

analyzing the companies in the STOXX® Europe 600.

One of the most common ways to calculate the cost of capital is to calculate

a company’s weighted average cost of capital (WACC). However, the inputs are

often debated, and in this piece we will focus on the options available when

calculating WACC.

1 Available at www.bofaml.com/corporatefinance.

Introduction


Lessons learned: The strong correlation between change in ROIC and total return

that we reported in our Q2 2013 publication, Calibrating ROIC to Drive Shareholder

Value, continues today. Based on our observation of S&P 500 companies’

performance over the past five years, as illustrated in Figure 1, the higher the

change in ROIC (3.4% for top quartile vs. -2.3% for bottom quartile), the higher

the annualized total return (28.0% for top quartile vs. 4.8% for bottom quartile).

Through our analysis and multiple discussions with our clients, we have learned

three key lessons for firms evaluating ROIC:

1. Recognize steady state ROIC: For many companies, base case ROIC may be

decreasing, despite projected strong operational performance (e.g., as a result of

capital intensity increasing). Companies must identify the true required capital

for a given level of steady state profitability.

2. ROIC is volatile: While increasing ROIC is correlated with higher total returns,

our analysis also shows that ROIC does not need to permanently improve. Like

all financial metrics, ROIC is expected to go through volatile periods, especially

when growth projects are pursued. Companies experiencing decreasing ROIC

year over year need to identify the reasons behind the trend. If ROIC decreases

are attributable to other benefits, such as growth initiatives, then a temporary

decline can be viewed positively.

3. Always manage the portfolio: A company’s portfolio of assets must be

actively managed into perpetuity. Companies should perform a periodic review

of all assets, including an analysis of separating subsidiaries, growth initiatives

and return of excess cash. Consistent deployment of capital and ongoing

reduction of underperforming capital bases should form a permanent part

of a company’s strategy.

*Source: FactSet

1 Revisiting ROIC

30%

25%

20%

15%

10%

5%

0%

5%

4%

3%

2%

1%

0%

(1%)

(2%)

(3%)

28.0%

4.8%

13.7%

19.2%3.4%

(2.3%)

(1.2%)

(0.0%)

Top ReturnQuartile

2nd ReturnQuartile

3rd ReturnQuartile

Bottom ReturnQuartile

5yr

Ann

ual T

otal

Ret

urn

5yr Annual Total Return

5yr

Cha

nge

in R

OIC

5yr Change in ROIC

Figure 1. 5-Year Annualized Total

Return vs. Change in

ROIC Over Past 5 Years*

Corporate Finance Topics | Issue No. 1 2015 2 Corporate Finance Topics | Issue No. 1 2015 3

The weighted average cost of capital (WACC)2 is a common means of assessing a

company’s cost of capital. WACC is based on a company’s cost of equity and tax-

effected cost of debt, with each cost weighted in proportion to its contribution to

the overall capitalization of the business.

While the formula for calculating WACC is generally accepted, there are several

schools of thought regarding how each underlying component should be calculated.

Risk-free rate: Both the cost of debt and cost of equity calculations factor in

the risk-free rate. Practitioners often base the risk-free rate on U.S. government

treasury bond rates, given the minimal amount of default risk. Because companies

are valued based on the business’s cash flows over the long term, there is general

agreement that the risk-free rate used to value the cash flows should similarly be

based on long-term rates.3 Specifically, some practitioners will say the risk-free rate

term should be consistent with the equity risk premium applied. However, shorter

term bonds may be appropriate for companies valuing a cash flow stream with a

finite life.

A bigger debate surrounds the use of current treasury rates vs. a historical average.

Some practitioners argue current rates are reflective of the best and latest market

views and should be used as is.

Others believe rates are temporarily low and are artificially depressed due to

government intervention; these practitioners argue a longer-term historical

average should be used. Currently, a 20-year treasury bond yields 2.39%, which

is significantly under the 10-year average yield for the 20-year of 3.90%. In

deciding whether to normalize, we believe companies need to apply consistent

treatment, factoring the same risk-free rate assumption (and implicit economic

growth assumption) into the cost of capital calculations and the cash flows being

discounted. For example, if low current risk-free rates are reflective of lower growth

and lower inflation, projected cash flows should reflect the same.

2 For purposes of these materials, WACC is calculated as (Debt/Capitalization * (Cost of Debt * (1 - Tax Rate))) + (Equity/Capitalization * Levered Cost of Equity).

3 Bank of America Merrill Lynch investment banking utilizes 20-year treasury rates.

Outstanding Questions

Risk-Free Rate Current vs. Normalized Long-Term Treasury Yields

Cost of DebtCurrent vs. Normalized

Blended vs. Marginal Cost of Debt

Equity Risk Premium Geometric vs. Arithmetic Mean

BetaBloomberg Beta vs. Barra Beta

Company’s Beta vs. Comparable Betas

2 WACC basics


Cost of debt: The cost of debt is also subject to the same normalization question

as the risk-free rate. In addition, there is also the question of whether to utilize the

marginal or blended cost of debt. To the extent a cost of capital analysis is being used

to measure incremental cash flows from incremental investment, the marginal cost of

debt is most appropriate. Bank of America Merrill Lynch investment banking typically

utilizes the overall blended cost of an unsecured long-term (10-year) note. Further, it

is best practice to base the cost of debt on the company or assets being valued.

Equity risk premium: The expected equity risk premium represents an estimate

of the excess return investors expect from taking on additional risk of investing

in equity securities, as opposed to risk-free government bonds. The equity risk

premium is generally based on a long history of data, given the cyclical nature of

market returns. By using long-term returns, practitioners can avoid the seemingly

random forecasts that short-term observations often produce.

The equity risk premium can be calculated by using either a geometric or arithmetic

mean of historical returns. The arithmetic average represents a simple average

of annual returns over a given period. The geometric average represents the

compounded return achieved over the same period, assuming reinvestment; it

reflects the return achieved had the investor hold the stock over the given time

period. For the 1926-2013 period, the equity risk premium’s geometric and arithmetic

means were 4.99% and 7.00%, respectively. For long-term, going-concern companies,

a geometric average would be more reflective of the return required by a long-term

investor. However, some view arithmetic risk premiums as more appropriate, given no

correlation between equity returns from one year to another.

Beta: The beta used in WACC calculations should estimate the risk of a

company’s future performance relative to the broader market. There are two

main sources for beta and each has its own merits based on the facts and

circumstances of the analysis.

1. Barra beta: The Barra predicted beta model is a multivariate model that

includes numerous factors impacting a company’s performance and risk

profile. Risk factors attributed to incremental equity risk premia are embedded

within the Barra predicted beta model, including a company’s size, currency

exposure, volatility, momentum, and financial performance.4 Barra re-estimates

a company’s exposure to underlying risk factors monthly in an effort to reflect

changes in the company’s underlying risk structure.

2. Bloomberg adjusted beta: Bloomberg betas are based on a historical

regression of a stock’s excess returns against an index. The betas are based on

observations across a specific time period that can be adjusted. The historical

time period chosen should balance recency with sufficient and relevant data

4Barra beta is derived from fundamental risk factors, which include 16 attributes for long-term investment horizons: value, profitability, growth, leverage, earnings quality, management quality, dividend yield, earnings yield, momentum, liquidity, beta, residual volatility, long term reversal, prospect, size and mid capitalization.


points; monthly observations over five years are often used. However, if there is

a significant event in the company’s history (i.e., acquisition, divestiture, spin-

off, change in business model, etc.), the beta observations should be taken as

of a date subsequent to the event. Bloomberg adjusts the historical data by

assuming companies’ betas will move toward the market average.5 Bloomberg

adjusted betas with low regression coefficients should also be eliminated, as

seen in Figure 2.6

Barra betas have the benefit of factoring in size, volatility and financial

performance, while Bloomberg betas only factor in historical data. However, the

merits of each approach are based on the facts and circumstances of the analysis.

Our proposed framework for choosing the appropriate beta is illustrated in Figure 3.

Generally, a public company’s own Barra beta should be used. However, the average

of an appropriate set of comparable companies may be used if there is a significant

change in the company’s business (i.e., acquisitions, divestitures, spin-offs, or changes

in business model, capital structure or liquidity). Because Barra betas include a size

premium, adjusted Bloomberg betas should be used in combination with appropriate

size premiums when using comparable companies of different size.

Figure 2. Beta Statistics**

Statistic

Barra Beta 1.16

Bloomberg Statistics

Beta R2

Monthly 0.88 0.11

Weekly 0.96 0.22

Daily 1.01 0.26

**Source: MSCI Inc. and Bloomberg.5Bloomberg adjusted beta is calculated as 67% * Raw beta + 33% * 1.0.6Represents actual Barra and Bloomberg betas for a specific company as of a specific date.7 Trading subject to unique or unusual circumstances (e.g., limited liquidity, large control blocks, takeover speculations, lack

of institutional investment and stock research sponsorship, extreme leverage, recent emergence from bankruptcy etc.).

Figure 3. Choosing a Beta

Am I a Private Company, Division, Public Company

with Volatile Trading History,7 or Micro Cap?

Use Adjusted Bloomberg Beta,

Size Premiums and Country Premiums

(as appropriate)

Use Barra Betas

ComparableCompanies Analysis

Use Company’sBarra Beta

Yes

Comps different size

Comps similar size

No


Hypothetical analysis: Based on the wide range of inputs available when calculating

WACC, practitioners can arrive at vastly different cost of capitals for the same firm.

For example, a firm is capitalized with 20% debt and 80% equity using the beta

statistics in Figure 2. Additionally, assume the firm has a 3.5% cost of debt spread

over treasury yields.

By varying the treasury yield, beta, and equity risk premium assumptions for this

firm, we find that WACC varies significantly, ranging from 6.7% to 10.6%. Thus, a

sensitivity analysis that incorporates a range should be performed as part of any

cost of capital analysis.

8 Size premium assumes company’s equity value between $10.1bn and $24.3bn.

Assumptions:

Treasury YieldCurrent 2.4%

Normalized 3.9%

BetaBloomberg 0.88

Barra 1.16

Equity Risk PremiumArithmetic 7.0%

Geometric 5.0%

Size Premium8Bloomberg 0.6%

Barra 0.0%

Treasury Yield BetaEquity Risk Premium WACC

Normalized Barra Arithmetic 10.6%

Normalized Bloomberg Arithmetic 9.5%

Current Barra Arithmetic 9.2%

Normalized Barra Geometric 8.7%

Current Bloomberg Arithmetic 8.1%

Normalized Barra Geometric 8.1%

Current Barra Geometric 7.3%

Current Bloomberg Geometric 6.7%


The global financial crisis demonstrated potential for dramatic and rapid shifts

in country-specific financial risks. Further, the crisis showed that country risk

calculated from traditional models may be disconnected from the perceived “real”

risk of businesses. As seen in Figure 4, companies can use two alternative methods

for capturing risk in international investments: (1) adjusting cash flows or (2)

adjusting discount rates.

The preferred method to account for international investment risk is to adjust cash

flows, as managers often have better insight into how risks will impact expected

cash flows. Local cash flows would be translated at the expected exchange rates

(to account for inflation) and then probability-weighted for other country-specific

risks. The resulting cash flows would then be discounted using a U.S.-based WACC.

However, when that is not possible, there are various ways to account for risks in

the WACC.

International cost of equity: International risk can be incorporated into the cost

of equity calculation and we highlight two methods here: (1) local/single country

CAPM and (2) sovereign spread.

1. Local/single country CAPM: This analysis uses local inputs to determine the

appropriate local cost of equity.

re = rf + β * MRPlm

• rf: Local risk-free rate

• β: Correlation to local market

• MRPlm: Local equity market risk premium

• Note: If all return estimates in local currency, discount rate applicable to local

currency cash flows, with resulting present value then translated to today’s

exchange rate

In theory, the local/single country CAPM method is preferred, as local inputs should

provide the best reflection of local risks. In practice, markets outside the U.S. do

not have a long history of efficient, established and liquid trading and thus may not

provide statistically relevant inputs.

Figure 4. Accounting for

International Risk

Accounting for risk ininternational investments

– Inflation– Country-specific

Local/SingleCountry CAPM

Sovereign Spread

Adjust cash flows

Adjust discount rate

3 International WACC


2. Sovereign spread: This approach combines the benefits of developed market

inputs for the calculation of the base WACC with an adjustment to account for

country-specific risks.

re = rf + (β * MRPdm) + MRPlm

• rf: Home (EUR/USD) risk-free rate (developed markets)

• β: Correlation to developed markets

• MRPdm: Developed equity market risk premium

• MRPlm: Regional equity market risk premium

The regional equity market return premium is calculated by first taking the yield

differential of the local country’s local currency denominated government bond vs.

a developed country’s bond, which accounts for certain country-specific risks. This

debt-based figure is then translated into an equity-based number by multiplying the

debt yield differential by the volatility of the local equity market relative to the local

bond market.

MRPlm = dls * (els/bls)

• dls: Bond default spread proxy to measure country risk

– Default spread measures default risk rather than equity risk; sovereign

bonds are affected by the same factors that drive equity risk, i.e., political

and currency stability

• els: Standard deviation of local equity market

• bls: Standard deviation of local bond market

This latter adjustment is largely limited to markets that have a history of bond

and equity market returns. Absent established markets, the bond yield differential

is simply added without the equity vs. debt volatility factor. It is also important to

use bond and equity markets that are denoted in local currency.

Cash flow vs. WACC adjustment: In theory, if risks are properly accounted

for, adjusting cash flows should result in the same present value as adjusting

WACC. Similar to checking the implied perpetuity growth rate when using EBITDA

multiples to calculate a terminal value in a discounted cash flow analysis, one can

calculate the implied local discount rate after adjusting cash flows. We illustrate a

simple example in Figure 5 to account for inflation risks.


Figure 5. Illustrative Foreign

vs. U.S. Cash Flows

Illustrative Foreign vs. U.S. Cash Flows

Year 2014F 2015F 2016F 2017F … 2024F

Cash Flows (Foreign) $100 $110 $121 $133 … $259

% Growth 10.0% 10.0% 10.0% … 10.0%

Inflation Rate (Foreign) 10.0% 10.0% … 10.0%

Inflation Rate (U.S.) 1.5% 1.5% … 1.5%

PPP Adjustment Factor 1.08 1.08 … 1.08

Exchange Rate Forecast 8.50 9.21 9.98 10.82 … 19.00

----->>>>> PPP Exchange Rate Forecast

Adjust Cash Flows

Year 2014A 2015F 2016F 2017F … 2024F

Cash Flows (USD) $12 $12 $12 $12 … $14

Present Value (at U.S. WACC) $11 $10 $9 … $5

Total Present Value (USD) $78

Implied WACC

Year 2014A 2015F 2016F 2017F … 2024F

Cash Flows (Foreign) $100 $110 $121 $133 … $259

Local WACC 19.2%

Present Value $92 $85 $79 … $45

Total Present Value (in Foreign Currency)

$660

Exchange Rate (USD / Foreign Currency)

8.50

Total Present Value (USD) $78

Implied International Risk Premium

9.2%

Assumptions:

Foreign Inflation 10.0%

U.S. Inflation 1.5%

Exchange Rate Purchasing Power Parity9

U.S. WACC 10.0%

9 Based on PPP, the expected exchange rate is a function of the current exchange rate and the expected inflation differential, calculated as follows: eexpected = ecurrent spot* (1+iFOR) / (1+ iUSD); where eexpected is the forecast or expected exchange rate, ecurrent is the current spot exchange rate, iFOR is the expected inflation rate for the foreign country and iUSD is the expected inflation rate for the domestic (USD) country.


Companies that have the most improvement in their ROIC generally also have

the best total shareholder return. A key consideration in determining which value-

maximizing projects to invest in is cost of capital. In theory, a greatly improving ROIC

should only maximize value if the cost to achieve the improvement is lower than

the improvement itself. WACC is one of the most commonly accepted methods of

calculating cost of capital, but debate continues over how certain WACC inputs are

calculated. When to use different types of beta and how to adjust for international

risk in a company’s cost of equity are two inputs that are highly situation-specific,

and each methodology has legitimate benefits and considerations.

Given the lack of consensus over how to calculate WACC, it is important to include

a sensitivity analysis with a range of costs as part of any cash flow discounting

exercise. Moreover, as it relates to international WACC, a useful exercise is to

project cash flows, adjusted for various risks, and cross-check the implied discount

rate with the discount rate that was derived using the WACC method.

4 Conclusion

Souren OuzounianHead of Americas Corporate Finance

[email protected]

646.855.5300

Jay [email protected]

646.855.4666

Leonard [email protected]

310.209.4062

Amir Mirza

[email protected]

646.855.4331

Philip [email protected]

646.855.4708

Gus [email protected]

646.855.4680

For more information, please contact:

bofaml.com/corporatefinance

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Merrill Lynch - Assessing Cost of Capital and Performance 2015

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