How often do companies re-calculate their Weighted Average Cost of Capital?
I'm working with a company that has over 60 locations around the country. This company typically builds four new locations every year. The company runs an NPV for each new location opportunity based upon expected five years of cash flow and a terminal value, all discounted back to the present using a Weighted Average Cost of Capital (WACC) or discount rate. The company last calculated its WACC in 2009. I am curious how frequently other finance professionals recalcute the WACC for their companies.
Answers (8)
Wallace J.
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Anna L.
Experienced Accounting Professional
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Hi Tom,
The re-calculation of WACC is probably required wherever any significant change of parameter(s) of the model is expected.
As WACC = E/V x Requity+ D/V x Rdebt (1-Tax rate of corp) , where Requity is likely to be determined from the CAPM where Re = Rf + βe (Rm-Rf),
Therefore, we can tell that when any one or more of the following situations happen, the WACC will be affected and re-calculation may perhaps be required:
- ratio of equity or ratio of debt to the total value (E/V or D/V) of the company is changed.
- Rate of return of equity is going to change which may be due to either or combine of the change of term deposit / GIC rate (Rf) , volatility of the share price of the company to the market as reflected by βe, and the average rate of market return (Rm)
- Rate of return of company debt which is highly related to the risk of the operation of the business is going to be adjusted.
- Tax rate of the corporation is going to be changed.
As in your case, the business is distributed in different locations in the country, therefore, the corporation tax rate of each business may be quite different from others even though there is no change expected on other parameters. Therefore, it really makes sense to determine NPV based on the WACC of each location separately.
Kamal G.
Director; CEO at Delta Petro Additives & EdSeva Software
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We calculate WACC every year. If interest rates are volatile, we do it more frequently.
The Reserve Bank of India went on a interest rate hike spree last year, and everytime it did that, we reset our WACC.
It depends on the capital structure and interest rates volatility, if its highly volatile then its better to recalculate the WACC more frequently than once a year
Bill C.
Connecting the dots between the economy . . . and business!
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I like annually. A 2009 figure assumes too little change.
However, I'm nervous about too frequent changes. If a project is thumbs up in January, but thumbs down in March solely due to changes in calculated cost of capital, I would question the methodology.
Asra I.
SAP Functional Analyst at Cargill
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the interest rate environment will dictate how often you want to recalculate -this has been relatively stable low rate enviornment.
Chung W.
Cash-Based Fixed Income / Credit Analyst
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I learn this answer from the horse's mouth from Tom Copeland, one of the primary and early authors in the book: "Valuation: Measuring and Managing the Value of Companies."
Professor Copeland stated there were ways of calcuating WACC. Most of the answers are based on text books, which is the standard way that has been listed earlier. Therefore, I will highlight the other two methods.
The second way is to assume a constant (or optimal) capital structure, say a long-term 60% debt and 40% equity even though at any point in time, the firm may deviated from 60/40 ratio.
The third way was to solve it simultaneously, which is a bit hard since you have more unknowns in one equation.
This gets to the heart of your question -- does a firm recalculate the WACC every second, i.e. when interest rates change, when it's beta changes, when the industry beta changes, when the industry leverage ratio changes, etc. I liked solving for valuations using the second approach better because it isn't subject to the whims of market noise.
In summary, if your firm has an optimal capital struture, and the cost of debt or cost equity or even tax rates hasn't changed much, using a theoretical WACC would make sense. Since WACC is very easy to calculate, and that interest rates are low these days, I am surprised your firm didn't update your WACC on a constant basis.
Good luck.
Mukund K.
Finance
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Usually you do it once a year & a sensitivity is built for interest rate changes.If the project is small then the guideline passed at begining of the year holds true, if the project cost is expected to be fairly large we build a base case of what it is at the moment.One can perhaps see what WACC is for 2009 & 2011 & then find out if projects were shelved or sanctioned. accordingly.
