What Are the Effects of High Cost of Capital?

The weighted average cost of capital is a method of calculating the cost of capital of a company based on the weighted average of the weight of the total capital source occupied by various types of capital. The source of capital includes common shares, preferred shares, bonds and all long-term debt. The cost of each capital (after tax) is calculated by multiplying it by its proportion of total capital and then totaled. Mostly used for company capital budgeting. ^[1]

Weighted average cost of capital

Used in financial activities to measure a company's

Weighted average

The operating risk of an enterprise can be calculated using the EBIT X

When we measure the expected cost of new capital, we should use the

How can I get the value of each component in the WACC formula? First notice that the weight of a financing source is equal to its

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With the gradual increase of the application of the income method in China's evaluation practice, new problems are also gradually increasing. Because the income method does not have historical cost as the basis of the asset addition method that most appraisers can use in the past, it requires more analysis and judgment, and has more changes and uncertainties. This is also a driving force for our appraisers to improve their business quality and strive to be in line with international standards as soon as possible. The most commonly used method of income is the discounted cash flow method, also known as the DCF method.

Evaluation method of weighted average capital cost

When assessing the value of a company using the income approach, appraisers use two methodsthe equity method and the investment capital method (sometimes called direct and indirect methods). The equity method evaluates the value of a company's equity by discounting the company's dividends or equity cash flows. This discount rate should reflect the rate of return required by equity investors. The investment capital method mainly focuses on and evaluates the overall value of the company, unlike the equity method, which only evaluates equity. The result of the investment capital law assessment is the value required by all claimants, including creditors and shareholders. At this time, the value of the required equity can only be the value of the company minus the value of the debt (so it is called the indirect method). The most common way to obtain the value of a company is to discount the cash flows of all investors of the company, including the cash flows of creditors and equity investors, and the discount rate is the weighted average cost of capital-a weighted cost of equity and debt. The average value is abbreviated as WACC in English. Therefore, WACC is an important calculation parameter for the valuation of investment capital (indirect) or the valuation of company equity (direct).

Application of weighted average capital cost method in individual project evaluation

What is worth noting when using the WACC method to evaluate the value of individual projects is to adjust the risks of individual projects according to the specific situation, because the capital weighted average cost is based on the enterprise as a whole, and is generally used for the assessment of the company's overall asset value. However, in reality, the vast majority of companies conduct diversified operations. For example, a production company may concurrently operate commercial or real estate, so different types of investment projects have different risks. It is obviously inappropriate to simply use the average cost of capital of a company for the evaluation of all departments and all investment projects of the company. Therefore, when using the WACC method to evaluate the value of individual risk items, the weighted average capital cost needs to be adjusted. For different risk items, different weighted average capital costs should be used to measure, and a specific acceptance standard for a specific project should be determined.

According to the formula rWACC = (S / B + S) × rs + (B / B + S) × rB × (1-TC), it can be seen that to calculate the capital cost of a project using the weighted average capital cost method, the factors that need to be determined are : Equity financing ratio: S / B + S; Debt financing ratio: B / B + S; After-tax debt financing cost: rB × (1-TC); Equity capital cost under leverage (debt) rs . If these four elements are determined separately, the WACC method can be used to evaluate the value of individual projects using mixed financing.

1. How is the debt and equity financing ratio determined for a specific project? It is worth noting that the ratio of debt financing and equity financing here must be determined based on the present value of the project rather than the present value of the company. When it comes to specific operations, there are two methods to choose from:

Assuming that the debt financing ratio of individual projects and the enterprise as a whole is the same;

Estimate a different debt financing ratio for a specific project.

2. The after-tax debt financing costs of individual projects are generally better determined and equal to the borrowing interest rate × (1- corporate income tax rate).

3. The key and difficult point in project evaluation using the weighted average cost method is how to determine the cost of equity capital (rs) of a project under leverage (debt). Even if there is an open and effective capital market, the cost of equity capital cannot be obtained directly because companies usually do not have stocks that are publicly listed for individual projects. They can only be obtained through indirect channels. According to the capital asset pricing model, the key to determining rs is to require a leveraged beta of the equity capital L, so the determination of rs can be obtained in three steps: first, obtain the beta of a single project without leverage ^ U; Then use the formula to convert U to L; finally, substitute L into the capital asset pricing model (CAPM) to find the cost of leveraged equity capital.

For the calculation of the cost of equity capital of a single project without leverage, U can usually be calculated in two ways: Qualitative analysis: That is, experienced financial staff and experts can use the sensitivity of the project's sales income and operating leverage to Project risk is estimated and appropriately adjusted down or up based on the weighted average cost of corporate capital. In practice, due to the large number and variety of enterprise projects, and some investment projects will not have a significant impact on the economic value of the enterprise, there is no need to spend a lot of manpower and resources to carry out project risk assessments one by one. Therefore, the method of dividing project risk levels can be approximated, and the risks that all projects of an enterprise may have are roughly divided into four risk levels: low risk; medium (average) risk; high risk and ultra high risk. In each divided risk level, the capital cost of a project is determined by the risk-free interest rate plus the risk premium corresponding to each risk level. The division of the four risk levels is shown in Figure 1:

The degree of risk of the four risk levels represented in the figure increases in order. The B grade represents the average risk level of an enterprise's project investment. The degree of risk of an individual investment project is judged according to its purpose after investment. The project's risk increases when it has the following four investment purposes: for increasing operating expenses; replacement of existing assets; for corporate expansion Or merger and acquisition; research and development of new products and projects. With the increase of investment risk, corresponding projects should also be classified to a higher risk level.

Quantitative calculation: value of the project = value of the total assets of the enterprise × relative risk coefficient of the project. The relative risk coefficient of the project = the risk of the project being evaluated / the risk of the standard project; further equal to the sensitivity of the project's sales revenue × the leverage of the project's operation / the sensitivity of the standard project's sales revenue × the standard's operating leverage. Then the calculated value of the project is substituted into the CAPM model to determine the equity capital cost U of the unlevered project.

After U is obtained, the beta coefficient L of leveraged (debt) items can be derived by the following formula: Because U = L × [S / B (1-t) + S] + B × (B / B + S), of which debt The beta B of financing is equal to zero, so: L = U ÷ [S / B (1-t) + S]. After L is obtained, the CAPM model can be used again to obtain the cost of equity capital rs for individual projects under the mixed financing method.

To sum up, when each component required to use the weighted average cost capital method is determined, it is substituted into rWACC = (S / B + S) × rs + (B / B + S) × rB × (1 -TC), you can calculate the capital cost of a specific investment project to make a funding decision: that is, to plan the total funding of the project according to the capital cost of the project; choose the source of funds; draw up a financing plan; determine the optimal capital structure.

In addition, based on the weighted average cost of capital, investment decisions can also be made on the project to determine the overall choice of the project. Specifically, when the NPV indicator is used for decision-making, the estimated cash flow (CF) after project investment is discounted at the weighted average cost of capital (rWACC), and then the initial investment amount is subtracted to obtain the project investment. The net present value (NPV) of the project can be calculated as follows: NPV = CFt / (1 + rWACC) t-the initial investment amount, and the net present value is feasible for a regular investment project; otherwise it is not feasible. When making decisions based on internal rate of return (IRR) indicators, the weighted average cost of capital is an important criterion for determining project choices. A project can only be accepted if its internal rate of return is higher than the cost of capital, otherwise it must be abandoned.

The important role of WACC method in project evaluation and its limitations

1. The WACC method, as an operation method for project evaluation in reality, has very important reference value and practical role, which is embodied in:

It can be used as a financial basis for investment opportunities for companies to choose projects. The investment should only be made when the expected return on investment opportunities exceeds the cost of capital.

It can be used by enterprises to evaluate the operating performance of the project unit capital operating internally, and to provide a basis for decision-making for project asset reorganization or continued additional funding. Only when the return on investment is higher than the cost of capital can the project unit continue to operate to have economic value.

(3) It is the basis for enterprises to dynamically adjust their capital structure based on changes in expected returns and risks. Enterprises with stable expected returns can reduce weighted average capital costs by increasing long-term debt and reducing high-cost equity capital.

2. In some specific situations, the WACC method has certain limitations when evaluating the value of a single project and is no longer applicable:

Because the company has no tax benefits for the time being, such as borrowing interest paid on debt financing can be deducted before tax or the tax is delayed due to corporate losses. The added value cannot be clearly revealed, which is not conducive to management's management and supervision of the value creation process.

The debt ratio in the project capital structure is dynamically adjusted throughout the life of the project and has not remained relatively stable. For example, in leveraged buyouts (LBOs), companies began to have a large amount of debt, but they were quickly paid off a few years later and the debt ratio fell rapidly. As the debt-equity ratio is not fixed, the WACC method is difficult to apply.

(3) The risks of new investment projects are quite different from existing projects of enterprises. If the risk of individual projects is ignored and the weighted average cost of capital is used as the sole discount rate for all investment decisions, it may mislead companies to abandon profitable investment opportunities and adopt non-profit investment projects.