Is It Fair to Value Stocks at Fair Value? Part 2
July 15, 2010
After CAPM, we now go to WACC or the Weighted Average Cost of Capital. WACC is the minimum return a company’s creditors and shareholders can expect from the company. WACC is CAPM times the Percentage of Equity to Total Assets plus the Cost of Debt times the Percentage of Debt to Total Assets times one minus the Corporate Tax Rate.
CAPM(% of Equity to Total Assets) + (Cost of Debt(% of Debt to Total Assets) x (1 – Corporate Tax Rate))
In the balance sheet of our sample company JFC, the Percentage of Equity to Total Assets is 54.78%, while the Percentage of Debt to Total Assets is 45.22%. JFC’s Corporate Tax Rate is likewise 35%, while its cost of debt is 6.4%. With these data, we arrive at a WACC of 5.23%.
In computing Fair Value, WACC is used as a discount rate or a rate that compensates for future risk that minimizes the value of the company. This is significant especially during these times that we encounter global economic turbulence. WACC discounts the future cash-flows of the company and also its terminal value or value over the long run or perpetuity. Since CAPM is a WACC component, one’s chosen CAPM assumptions also influence what the WACC will be. High CAPM assumptions results to a high WACC, and being a discount rate, gives a lower fair value. Investors who prefer high WACCs have high expectations of returns from the company.
Since WACC is a discount rate and the minimum return an investor expects from the company, it is advisable to choose low CAPM assumptions such as the 364 Day Tbill Rate as the Risk Free Rate and the Average Corporate Bond Yields as the Market Rate from Part 1. This gives a rational WACC which does not heavily discount future cash-flows. Using WACC is one of the beauties and strengths of Fair Value. Here, the valuation is made conservative as it compensates for future risk.