Download - The WACC: A Sceptic's View
Slide 2
Standard Approach toCost of Capital
• Use CAPM to estimate expected return onequity.
• Combine with observed cost of debt toestimate WACC: min expected return sufficientto cover debt costs and provide acceptablereturn to stockholders.
• EITHER use WACC to calculate NPVOR compare WACC (hurdle rate) with IRR.
Slide 3
Technical Assumption
Can use financial market prices tovalue new projects.
• But new project cannot alter set ofavailable investment opportunities(Spanning)
• If it does, its introduction changes risk ofexisting securities
• Then cannot use current securities pricesto infer risk of new project
Slide 4
Spanning
• “(Without spanning), much of what istaught on capital budgeting would go outthe window.” (Martin Weingartner, Journalof Finance, 1977)
• Hope that financial markets are sufficientlydeep and liquid
Slide 5
Some implications of theStandard Approach
• Only systematic risk matters
• Cost of capital for any project is the sameregardless of the firm that undertakes it.
• Project that could wipe firm out can havesame (or lower) cost of capital than saferproject.
Slide 6
Example(Rene Stulz, FPE, 1999)
• Firm has market value of $120m and cashof $110m
• Coin toss: Heads +$102m; Tails -$100m• No systematic risk; no time value• WACC = 0• NPV = $1m > 0
BUT WOULD ANY SANE FIRM TAKE IT?
Slide 7
Problems with theStandard Approach
Standard Approach takes no account of• total risk (volatility)• indirect costs
In a perfect static world, these don’t matter
In an imperfect dynamic world, formercreates latter.
Slide 8
The Standard Approach andTotal Risk: The CAPM
John Cochrane:• "We once thought that the CAPM provided a
good description of why average returns onsome stocks, portfolios, funds, or strategieswere higher than others. Now we recognise thatthe average returns of many investmentopportunities cannot be explained by theCAPM..."
• "In sum, it now appears that investors can earna substantial premium for holding dimensions ofrisk unrelated to market movements..."
Slide 9
The CAPM cont.
• CAPM can only explain at most 11% ofvariation in NZ stock returns
• "Relying on the CAPM ... for cost of capitalcalculations ... is dubious." (Bartholdy etal, 1997)
Slide 10
Why does the CAPM performpoorly?
• Parameter measurement errors
• Missing factors: Non-traded assets- high (low) demand for good (bad) hedges
• Human Capital - prefer stocks that do well in recessions
Slide 11
Two-beta CAPM(Campbell and Vuolteenaho, 2003)
• Betas reflect common variation in cashflows?• “Whether (gold prospectors) strike it rich is not likely to
depend on the performance of the market portfolioTherefore, an investment in gold has a high standarddeviation but a relatively low beta.” (Brealey and Myers,1991)
• Ignores common variation in expected returns (discountrates)
• So actually have two sources of beta risk, each withdifferent premium
• Two-beta model works better
Slide 12
The Standard Approach andIndirect Costs
• New project that costs I changes firm value F by
(Fafter - Fbefore) = (Vproject - I) + (Aafter - Abefore)
• SoWACC+ = WACC (1 + DA/I)
for DA = (Aafter - Abefore)
Slide 13
Indirect Costs I: Market frictions
• Project with high total risk can weaken the firm'sfinancial position
• Weaker financial position can adversely affectvalue of other firm projects/opportunities: indirectcost
• Standard approach assumes financing isunconstrained and costless, i.e., frictionlessmarket: firm's financial position has no effect oncost of project
Slide 14
Example: CatastropheReinsurance
• High volatility of returns on catastrophereinsurance, but diversifiable and thus shouldnot command a risk premium
• In 1996, Berkshire Hathaway agreed to sell$1.05 billion of reinsurance to the CaliforniaEarthquake Authority– Probability of BH having to pay anything =
1.7%– Premium was $113 million (633% of the
expected loss!) vs SA premium of $17.85million
Slide 15
Indirect Costs II:Timing Flexibility
• Most projects can be delayed and are at leastpartly irreversible
• Firm holds an 'option' to invest at the 'best' date
• When investment begins, firm sacrifices option
• 'Loss' of option is an additional cost of project
• More total risk makes option more valuable
Slide 16
Indirect Costs III: Other Sources
• Asymmetric information
• Subordinated securities
• Human resource constraints