Treasury Today Country Profiles in association with Citi

Calculating WACC – an art not a science

The standard weighted average cost of capital (WACC) calculation that corporates use for budgeting analysis is increasingly thought of by some finance professionals as an “imperfect measure”, a recent survey has found.

There is no doubt that the inputs that corporates put into the measure have altered dramatically in recent years – interest rates and borrowing costs remain at record lows, and volatility continues to be on the increase in the stock exchanges. But does this mean that some corporates are beginning to lose confidence in the tool?

That is the question posed in a recent article by Michael Jacobs, a finance professor at the University of North Carolina’s Kenan-Flagler business school. Writing in the Harvard Business Review last month, Jacobs asserts that the wrong inputs are being used in a significant number of cost of debt and equity calculations, something which he reasons may “profoundly affect both the type and the value of the investments a company makes”.

Jacobs’s article drew on data from a survey conducted by the Association of Finance Professionals (AFP) which asked 15,000 finance professionals how they calculate their cost of capital – in basic terms, the weighted average of a company’s cost of debt and its cost of equity.

The AFP survey found that the process for evaluating the potential viability of financial investments is not as uniform as one would expect, with different corporations inputting different measures of tax and debt into their calculations. Even more worrying is the lack of certainty in the accuracy of cost of capital estimates reported by many respondents. The report found that 55% of those surveyed believed that their WACC estimates were inaccurate by more than 50 basis points – with only a small fraction (17%) reporting accurate estimates of within 25 basis points.

With companies reported to be hoarding a record $2 trillion in cash and short term liquid assets last year, this level of inaccuracy could have significant macro-level implications, Jacobs believes. A lack of consensus on the best way of measuring capital costs could cause corporates to grow more cautious when picking which projects to invest in. And this in turn could be something which might impede troubled western nations in their efforts to turn around their fragile economies – many of which continue to be characterised by high unemployment and anaemic levels of growth.

However, despite the apparent significance of this erroneousness for the health of the wider economy, not all corporate treasurers are convinced that cost of capital valuations can ever be completely precise. “This is not an exact science” says Sam Horrocks, Assistant Treasurer, Corporate Finance, at Virgin Media. “Because each company will be using different measures, some companies will be making good decisions and some, inevitably, will be making bad decisions. But in reality you’ll never control that. The important thing is that your basic criteria, within a certain margin of error, represents a reasonable assessment of your true cost of debt and your true cost of equity. If you then apply that consistently, it doesn’t really matter that you haven’t got a textbook answer” he says.

What does matter, however, stresses Horrocks, is that companies remain disciplined and act in a capital-constrained manner. “If you’re applying things on a consistent basis and you’re evaluating more projects than you really have cash to spend, you set a suitably high bar which allows you to operate in a capital-constrained environment.

Consequently, a small margin of error in your cost of capital calculation is unlikely to ever be an issue for you,” he says. “At Virgin Media we have quite strict capital guidelines that we place on ourselves – with cash capital expenditures around 15-17% of revenue” he adds. “That self-imposed range forces us into a very disciplined process of capital evaluation. When you’re operating in that environment, some of these potential investments will inevitably fall below the bar. But as long as you have enough above that bar, it doesn’t really matter if you haven’t got that calculation 100% accurate.”