Extended WACC Formula Workout
- 03:42
Calculating WACC using the extended WACC formula.
Transcript
In this workout, we've been asked to calculate the WACC for a company looking at two possible scenarios. First of all, assuming there's no cash in the target capital structure, and secondly, assuming that cash is 5% of EV in the target capital structure. Now, in both scenarios, we'll assume that equity is 60% of EV. The first thing to note is that we've been given some assumptions for the cost of equity, the cost of debt, and the return on cash. And we've also been told that the marginal tax rate for this company is 21%. So let's start with the first scenario which is assuming that there's no cash in the target capital structure. So we're gonna use the standard WACC formula for this. We'll start with the equity term which is to take the cost of equity multiply it by the proportion of equity, which is 60%. We're then gonna add to that the cost of debt, multiply it by the proportion of debt, which is one minus our 60%, and then we need to remember there's a tax shield on debt so we'll multiply that by one minus our marginal tax rates. So that gives us a cost of capital of 6.5%. Now let's have a look at our second scenario where we assume that cash is 5% of EV. Now we need to remember that EV is the sum of our debt plus our equity, less any financial assets. So if equity remains at 60% of EV we are gonna need to adjust the amount of debt in a target capital structure. So that's gonna be one minus the proportion of equity plus the proportion of cash. So that means that debt will be 45% of EV in a target capital structure. So we've now got everything we need to use the extended WACC formula. We'll start off again with equity, (mouse clicking) multiply that by the 60% of equity. We then add to that the cost of debt multiplied by the proportion of debt that we've just adjusted. And then we multiply that by our tax shield.
But this time we now have an extra return for the cash. And remember it's a return on cash rather than a cost, so we're gonna deduct that from our cost of capital. So we take the return on cash of 2%, multiply it by the 5% proportion, and then because that return on cash is gonna incur tax, we're gonna multiply that by one minus the marginal tax rate. So we now have an adjusted or revised WACC of 6.6% when we incorporate cash into the targets capital structure. Now I think there's are two really interesting things to highlight here. The first thing to note is that the result that we get if we include cash in our extended WACC formula is quite different to the result that we would've got if we'd used net debt in the traditional WACC formula. And that's because if you include net debt in your WACC formula, you are implicitly assuming that the return on cash is the same as the cost of debt. And that's certainly not the case here. And in reality, it's rarely the case. But the second thing that's really interesting is that by including our cash in our target capital structure, we actually increase the cost of capital of the company. And the reason for this is that actually it's quite an inefficient capital structure. If the company is generating a return of just 2% on cash and that's being financed by additional debt at three and a half percent, then it's actually very inefficient for the company. And that's one of the reasons we have to be very careful about including cash and financial assets in the target capital structure. And usually that would be the case if there is some kind of regulation or other structural issue which requires the company to hold cash in its balance sheet for the long term.