Weighted average cost of capital evaluation method
When using income method to evaluate the value of a company, appraisers widely use two methods-equity method and investment capital method (sometimes called direct method and indirect method). Equity method is to evaluate the value of a company's equity by discounting its dividend or equity cash flow, and 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 the equity. The evaluation result of investment capital method is the value required by all claimants, including creditors and shareholders. At this time, the value of the required rights and interests can only be the total value of the company MINUS the value of the creditor's rights (hence the indirect method). The most common way to calculate the value of a company is to discount the cash flow of all investors in the company, including creditors and equity investors. The discount rate is the weighted average cost of capital, that is, the weighted average cost of equity and debt, which is abbreviated as WACC in English. Therefore, WACC is an important calculation parameter to evaluate the investment capital value (indirect) or the company's equity value (direct).
Application of weighted average capital cost method in single project evaluation
When using WACC method to evaluate the value of a single project, it is worth noting that the risk of a single project should be adjusted according to the specific situation, because the capital-weighted average cost is generally used to evaluate the overall asset value of a company. However, in reality, most enterprises are diversified. For example, a production enterprise may run business or real estate at the same time, so different types of investment projects have different risks. It is obviously inappropriate to evaluate all departments and investment projects of the company only by the average capital cost of the company. Therefore, it is necessary to adjust the weighted average cost of capital when using WACC method to evaluate the value of a single risk project. For projects with different risks, it is necessary to use different weighted average capital costs to measure and determine a specific acceptance standard for specific projects.
According to the formula Rwacc = (S/B+S) × RS+(B/B+S )× Rb× (1-TC), it can be seen that the factors to be determined in calculating the capital cost of a project with the weighted average capital cost method are: (1) equity financing ratio: S/B+S; (2) Debt financing ratio: b/B/b+ S；; ⑶ After-tax debt financing cost: Rb× (1-tc); ⑷ The cost of equity capital under leverage (debt) rs. If these four factors are determined separately, WACC method can be used to evaluate the value of a single project with mixed financing.
1. How is the ratio of debt to equity financing determined for specific projects? It is worth noting that the ratio of debt financing to equity financing here must be determined according to the present value of the project rather than the present value of the company. In the specific operation, there are two methods to choose from:
(1) Assume that the debt financing ratio of a single project and the whole enterprise is the same;
(2) Estimate different debt financing ratios for specific projects.
2. The after-tax debt financing cost of a single project is generally easy to determine, which is equal to the loan interest rate ×( 1- enterprise income tax rate).
3. How to determine the cost of equity capital (rs) of the project with leverage (debt) is the key and difficult point when evaluating the project with the weighted average cost method. Even if there is an open and effective capital market, the cost of equity capital cannot be obtained directly, because enterprises usually do not have publicly listed stocks for a single project, but can only obtain them through indirect conversion. According to the capital asset pricing model, the key to determine rs is to require the leverage beta βL of equity capital, so the determination of rs can be obtained through three steps: first, calculate the leverage beta U of a single project; Then use the formula to convert βU into β l; Finally, substitute βL into CAPM to calculate the cost of leveraged equity capital.
(1) For the calculation of the capital cost of a single project without leverage, βU can usually be calculated in two ways: (1) Qualitative analysis: experienced financial personnel and experts estimate the project risk according to the sales revenue of the project and the sensitivity of operating leverage degree, and appropriately reduce or improve it on the basis of the weighted average cost of enterprise capital. In practice, due to the huge number and variety of enterprise projects, and some investment projects will not have a significant impact on the economic value of enterprises, it is not necessary to spend a lot of manpower and material resources to conduct project risk assessment one by one. Therefore, the possible risks of all projects of an enterprise can be roughly divided into four risk levels by the method of dividing project risk levels: low risk; Moderate (average) risk; High risk and ultra-high risk. In each risk level, the capital cost of the 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 risk degree of the four risk levels shown in the figure increases in turn. Grade B represents the average risk degree of enterprise project investment. The risk degree of a single investment project is judged according to its post-investment purpose. The risk of projects with the following four investment purposes increases in turn: increasing operating expenses; Replace existing assets; Used for enterprise expansion or mergers and acquisitions; Conduct research and development of new products and projects. With the increase of investment risk, each project should be classified into a higher risk level accordingly.
② Quantitative calculation: β value of project = β value of total assets of enterprise × relative risk coefficient of project. Relative risk coefficient of the project = risk of the evaluated project/risk of the standard project; Further equal to project sales revenue sensitivity × project operating leverage/standard project sales revenue sensitivity × standard project operating leverage. Then, by substituting the calculated β value of the project into CAPM model, we can determine the equity capital cost βU of the leverage-free project.
⑵ After obtaining β U, βL of leveraged (debt) projects can be derived from the following formula: because β U = β L× [s/b (1-t)+s]+βB× (b/b+s), where β B of debt financing is equal to zero, there is: β L = β U ÷. After obtaining βL, CAPM model can be used to calculate the cost of equity capital rs of a single project in mixed financing mode again.
To sum up, when determining the various components required for using the weighted average cost capital method, we can calculate the capital cost of specific investment projects and make financing decisions by substituting Rwacc = (S/B+S )× RS+(B/B+S )× Rb× (1-TC) one by one: that is, plan the total amount of project financing according to the project capital cost; Select the source of funds; Draw up a financing plan; Determine the best capital structure.
In addition, according to the weighted average cost of capital, we can also make investment decisions and determine the overall choice of the project. Specifically, when NPV index is used for decision-making, the expected cash flow (CF) generated after project investment is discounted according to the weighted average cost of capital (rWACC), and then the initial investment is subtracted to get the NPV of project investment. NPV after project investment can be calculated as follows: NPV=∑CFt/( 1+rWACC)t- initial investment, and NPV is a conventional investment project. Otherwise, it is not feasible. When making decisions based on internal rate of return (IRR), the weighted average cost of capital is an important criterion for determining project selection. Only when the internal rate of return of the project is higher than the cost of capital can the project be accepted, otherwise it must be abandoned.
The important role and limitations of WACC method in project evaluation
1.WACC method, as an operation method of project evaluation in reality, has very important reference value and practical value, which is embodied in the following aspects:
(1) can be used as a financial benchmark for enterprises to choose project investment opportunities. Only when the expected rate of return on investment opportunities exceeds the cost of capital should investment be made.
⑵ It can be used for enterprises to evaluate the capital operation performance of project units that are operating internally, and provide decision-making basis for project assets reorganization or continuing to add funds. Only when the return on investment is higher than the cost of capital can the project unit continue to operate and have economic value.
(3) It is the basis for enterprises to dynamically adjust their capital structure according to the changes of expected returns and risks. Enterprises with stable expected returns can reduce the weighted average cost of capital by increasing long-term liabilities and reducing high-cost equity capital.
2. In some specific cases, WACC method is no longer applicable because it has limitations in evaluating the value of a single project:
(1) Because enterprises have the privilege of not paying taxes for the time being, for example, loan interest paid by debt financing can be deducted before tax or tax payment can be postponed due to losses of enterprises. At this time, if WACC method is adopted, the value increase caused by tax evasion cannot be clearly revealed, which is not conducive to the management and supervision of the value creation process.
(2) The debt ratio in the capital structure of the project is dynamically adjusted during the whole life cycle of the project, and has not remained relatively stable. For example, in leveraged buyout (LBO), the enterprise started to have a large amount of liabilities, but it was quickly paid off after a few years, resulting in a rapid decline in the debt ratio. Because the debt-equity ratio is not fixed, WACC method is difficult to apply.
⑶ The risks of new investment projects of enterprises are quite different from those of existing projects. If the weighted average cost of capital is applied to the investment decision of all projects without considering the risk of a single project, it may mislead enterprises to give up profitable investment opportunities and adopt non-profit investment projects.