Appendix D: The Weighted Average Cost of Capital (WACC)
D.1 The weighted average cost of capital (WACC) is the minimum acceptable return on investment required by lenders and shareholders. It is the weighted average cost of debt and equity funded capital and is the appropriate rate to discount future Free Cash Flows (FCF) to their Present Value (PV).
D.2 The WACC is used for EV valuation purposes. First is used in assessing whether network segment assets can sustain an Optimised Depreciated Replacement Cost (ODRC) valuation, or whether they should be valued at EV. Secondly if such assets are unable to sustain an ODRC valuation, the WACC is used to discount the future expected cash flows of those assets to calculate their PV and EV.
D.3 The WACC may be defined in alternative ways. Below a commonly used definition is presented. The handbook does not mandate the definition to be used, but whatever WACC formulation is used, it should be consistent with the formulation of the cash flows to be discounted. The WACC in this handbook has been specified from a New Zealand investor perspective. It is presented as post-investor tax to reflect New Zealand's dividend imputation regime, and it is set in nominal (not real) terms consistent with FCF.
The WACC Formula
D.4 The WACC may be determined as:
| where: |
Re |
= |
cost of equity capital |
| |
Rd |
= |
cost of debt |
| |
E |
= |
market value of equity |
| |
D |
= |
market value of debt |
| |
V |
= |
D + E = total value of business |
| |
tc |
= |
corporate tax rate on debt. |
Cost of Equity Capital (Re)
D.5 The cost of equity capital (Re) is the return required by investors to compensate them for the variability of bottom line profits. It is equivalent to a cost of capital which includes both business risk (arising from the variability of operating cash flows, and financial risk (arising from the variability of residual cash flows after paying interest payments out of uncertain profits).
D.6 Remay be determined using the Capital Asset Pricing Model (CAPM) as:
| where: |
Rf |
= |
risk free rate |
| |
Rm |
= |
return on the market portfolio of shares post-investor tax |
| |
Rm-Rf (1-tc) |
= |
equity market risk premium post-investor tax |
| |
ße |
= |
equity beta (levered). |
D.7 The CAPM can be configured on either a pre or post-investor tax basis. The latter is theoretically superior and the handbook has adopted its use. This does not preclude the use of WACC on a pre-investor tax basis but the inputs to the WACC will differ from those discussed below.
The Risk Free Rate (Rf)
D.8 The most suitable risk free rate is a government stock rate, say for 5 year stock. This rate is widely available as active trading in 5 year government stock means it is likely to be an equilibrium rate, and it is the generally accepted indicator of the risk free rate.
Equity Market Risk Premium (Rm-Rf (1-tc))
D.9 The post-investor tax market risk premium can be calculated from New Zealand share market data. An estimate should be used for this factor which is both theoretically and empirically defensible. The basis of measurement should be consistent with that used for the determination of the equity beta coefficient.
Equity Beta (ße)
D.10 The equity beta coefficient will depend on the relative business and financial risk of each ELB. Equity betas can be expressed in terms of a asset betas, which are a measure of relative business risk alone (the financial risk of leverage is excluded from asset betas). The relationship of equity betas to asset betas is:
| where: |
ße |
= |
equity beta (levered) |
| |
ßa |
= |
asset beta (unlevered). |
D.11 Asset betas can be estimated from of firms listed on the New Zealand Stock Exchange with comparable levels of business risk as well as firms listed on overseas markets. Shares in electricity utilities are traded on a number of overseas markets. However, caution and judgement is required in applying data derived from other markets as this may be derived from capital markets which exhibit different characteristics to New Zealand capital markets.
The Cost of Debt (Rd)
D.12 The borrowing rate should be estimated as the risk free rate plus a premium that will reflect the riskiness of the debt of the particular line ELB:
The Debt and Equity Ratios (D/V and E/V)
D.13 The debt and equity ratios should be set consistent with ratios considered to be prudent by equity markets for comparable businesses. As well as referring to the New Zealand market which has limited examples of such businesses, examination of overseas markets may provide useful input.
D.14 An important factor influencing a particular firm's debt ratio is the level of business risk facing the firm. A low risk firm with stable cash flows can prudently support a high debt ratio. A firm with higher risk characteristics will normally only be able to support lower debt levels as troughs in its more volatile cash flow could create liquidity problems if debt (and therefore debt servicing cost) is relatively high.
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