1 ACCC Forum 2 April 2004 A WACC Sanity Check Kevin Davis Commonwealth Bank Group Chair of Finance Department of Finance The University of Melbourne

2 ACCC Forum 2 April 2004 Operating and Financial Risk Financial arrangements can change value of a business activity –Tax shields, agency issues, signalling Equivalently Financial arrangements can change required rate of return for the cash flows of the business activity measured ignoring financing cash flow effects –Reduce traditional WACC relative to all-equity financing Used to value cash flows calculated as if company unlevered

3 ACCC Forum 2 April 2004 Operating and Financial Risk Equivalently Cash flows of business inclusive of financing arrangement effects such as interest tax shield can be modeled Vanilla WACC is appropriate discount rate –Equal to cost of capital for all equity financing (unless some tax or other effects omitted in cash flow modeling) May be some adjustment required if leverage not constant (systematic risk of tax shields then differs to that of assets)

4 ACCC Forum 2 April 2004 Estimating Vanilla WACC (approach a) Step 1 – what is the cost of capital for the business activity on all-equity finance basis? –CAPM requires asset beta, risk free rate, and market risk premium Step 2 – are there any other effects of financing arrangements not already captured in cash flows? –Are all tax effects captured in cash flows? –Does debt policy mean some adjustment is required? –What other costs/ benefits might be considered?

5 ACCC Forum 2 April 2004 Estimating Vanilla WACC (approach b) Given financing arrangements –Estimate required rate of return for each type of finance (equity, debt) and aggregate Cost of equity - CAPM requires equity beta, risk free rate, and market risk premium Cost of debt – CAPM or debt margin approach

6 ACCC Forum 2 April 2004 Approach a or b? Both are equivalent, if full information is available. In practice, where relevant parameters must be estimated using imperfect information – approach b appears to give more scope for “cherry picking”

7 ACCC Forum 2 April 2004 Key Issue #1 Does the longevity of regulated assets imply use of a long term risk free rate of interest in calculating WACC? No! No evidence that asset beta is linked to project life –Individual suppliers of capital (eg shareholders) can exit project at any time by trading listed equity –Regulatory approach means cash flows adjust over time to changes in market conditions (real & financial) Benefits from financing arrangements may depend on project life –Can be captured in cash flow modeling

8 ACCC Forum 2 April 2004 Key Issue #2 Does consistency with estimation of MRP require use of long term (10 year) risk free rate? No! MRP is a forward looking “guesstimate” Historical estimates relevant, but –Many good arguments about impact of fundamental changes in financial and real markets and tax on MRP –10 year bond characteristics and bond markets have changed markedly over time

9 ACCC Forum 2 April 2004 Key Issue #3 Should Cost of Debt be benchmarked off long term bond rate. No! –Calculation of cost of debt unnecessary if Vanilla WACC calculated using asset beta Asset life and debt characteristics –May aim to match interest rate risk of debt with that of operating cash flows –Maturity and interest rate risk can be easily decoupled –Credit spread of longer term debt may be appropriate But overstates required rate of return spread for discounting expected cash flows

10 ACCC Forum 2 April 2004 Key Issue #4 Does the debt beta matter? Not much! For a given asset beta –Higher debt beta offset by lower equity beta Vanilla WACC calculation should be largely invariant to debt beta

11 ACCC Forum 2 April 2004 Key Issue #5 Does the Levering - Delevering formula matter? Not Much Not needed if asset beta known and vanilla WACC calculated directly from that Using “Monkhouse” formula to estimate equity beta involves a non-material difference.

12 ACCC Forum 2 April 2004 Conclusions My preference – use cost of capital based on asset beta for vanilla WACC –But how to determine asset beta? Case for using long term (10 year) risk free interest rate is weak.