BV of equity & debt to MV of equity & debt while calculating the debt to equity ratio for WACC

Replies to This Discussion

Permalink Reply by Sachidanand (Sacha) Singh on November 23, 2008 at 7:20pm

1. Two good reasons for using MV and not BV. First, since all valuations are practically acquisition valuations ( firm or part) it makes sense to start with market value. Second, limited liability nature of equity does not permit us to consider negative value for equity, but book values do at times get negative
2.Yes, taking any value (BV or MV) for estimating Ke in essence means that we have already assigned the value of equity. You correct it by itereation. You get your Ke with MV, get the value of equity with Ke and use this value as weight next time. Keep on doing it till the difference is small enough to be acceptable. If you do not mind switching on iteration in excel (I do) it is a matter of split second; if you do it is a matter of a few minutes.
3. If the debt is having floating rate (most term loans in India are now floating rate) then it is I think ok to assume BV of debt is equal to MV of debt (after all bank is resetting the rate with changes in term structure). If it is fixed interest loan then you must do some sort of rating exercise to arrive at the appropriate spread for the borrower, determine the market driven rate and discount the cashflows to get market value of debt
4 I could not fully follow your 4th point. Suppose the firm borrowed originally 100 and present outstanding is 80. We will take 80 if it is a floating rate loan. If it is a fixed rate debt, we consider two cases. Suppose rates have since gone up and the firm would be able to raise money at a lower rate, the acquirer (covenants permitting) would raise 80+ at lower rates pay 80 to bank and firm would have the extra cash! If you take BV of 80 you lose site of this item. Alternatively if the interest rates have gone up, the lender would not agree to the acquisition (approval required as per the Companies Act). Acquirer will have to raise monies - teh amount which was servicing 80 will now be able to service less than 80 and the acquirer will have to make good this shortfall for acquisition.

Is the 4th point clear?

▶ Reply to This

Permalink Reply by Govind on November 23, 2008 at 11:43pm

Thanks for the clarification Sacha......

▶ Reply to This

Permalink Reply by oyebola.O on February 2, 2009 at 10:12am

Book values does not show true and current position of the company,because it's historical in nature but the current value is being used because it shows the present worth of a company as at the reporting period.

▶ Reply to This

Permalink Reply by Evron on February 2, 2009 at 10:57am

In addition, assuming the firm needs to borrow to pay off the existing debt, it may have to borrow at the cost of the Debt's Market Value (Today's Value) rather than on its historical value...it therefore makes sense to assume that the current value of the debt is equal to its present value.

▶ Reply to This

Permalink Reply by Les Livingstone on February 2, 2009 at 12:39pm

I disagree. If the capital project will use new funds to be obtained from new issues of debt or equity, then those market values should logically be used.

But if the capital project will use existing funds, then book values should be used. The firm's cost of debt is the debt service on existing debt obligations, and not some market value for a transaction that will not even take place. However, if the capital project will use existing funds, the cost of equity should be the return expected by the equity holders - and this is the market cost of equity. So I believe if the capital project will use existing funds, the WACC is debt at book cost, but equity at market cost.

Is this contradictory? No: debt carries pre-agreed fixed costs, but equity embodies current expectations because (unlike debt or preferred) equity has no pre-agreed fixed cost.

▶ Reply to This

Permalink Reply by AHMAD on February 3, 2009 at 12:39am

This makes absolute sense.
thank you

▶ Reply to This

Permalink Reply by sergei on February 3, 2009 at 4:28am

The WACC fomula have been developed for the Free Cash Flow to Firm and the market values referred are the present values of future cash flows. The derivation of the formula requires that the present (market) values of cash flow to equity and cash flow to debt be used. And in no cases the use of book values is admissible. That's all. If you use book values the formula loose underpinnings and you'll produce distorted values. Note that the WACC calculation should strictly corresponde to the cash flows valued. It should involve tax bracket (1-T) for FCFF and should not involve it for CCFF.

▶ Reply to This

Permalink Reply by Mahinda. D. N. Vito on February 3, 2009 at 8:44am

true,debt carries pre-agreed fixed costs, but then when you look at the cost of debt, there is a premium attached to it Kd=Rf+credit premium.
the credit premium varies with default risk of the firm which inturn depends on firms gearing

▶ Reply to This

Permalink Reply by Sachidanand (Sacha) Singh on February 22, 2009 at 3:48pm

I have some doubts about your argument. I shall be grateful if you could explain.

What I understand is (correct me if I have got it wrong): a firm is undertaking a new project. The viability of the project is to be established by NPV method. To keep it simple we take it that the project will be funded only with straight debt and equity. The discount rate will then be weighted average cost of debt and equity. Cost of debt, you suggest should be the cost at which the firm has already borrowed. Even if we accept that the firm had borrowed more than what it needed at the time of borrowing and that those funds are now deployed for the project, I feel by doing so we are equating the credit risk of the project with the credit risk of the firm. Is it correct? I understand if the project is undertaken in the firm itself (i.e. not in a new special purpose subsidiary) then the firm is liable for servicing the debts assumed for the project but by equating the cost of debt of the project with the cost of debt of the firm, if the firm has strong asset base / finanicals etc shall we not be over valuing the project? This is so far as evaluating a project is concerned.

In valuation of a running firm, suppose the firm has 100 of debt on book. Also suppose it was contracted some time back in a low interest rate regime. I wish to acquire the firm. Standard covenants in loan agreements would dictate that teh loan be repaid with change in management and I will have to repay the loan. I pay 100. I now wish to borrow. Will I be able to raise 100 on the strength of the cashflows of the firm? If the cashflows remain unchanged and earlier say x was available for servicing the debt and bank had lent 100 when the rate of interest for this risk was say a. Obviously 100 was x/a. Now with rate of interest being b, I will be able to raise x/b. As b is higher than a (we have moved into a high interest rate regime) I will be able to raise somewhat less than 100 and the difference will get added to my cost of acquisition. Therefore, I feel, we need to consider market value of debt while valuing a running firm too.

I feel, as Sergei has put below, when estimating WACC, we should not be interested in past investments but in current values and expectations for the future. It holds as much for debt as for equity. Book values obviously are not current values.

▶ Reply to This

Permalink Reply by Diego B. Ledda, Jr. on February 2, 2009 at 10:37pm

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

E D
WACC = --- * Re + -- * Rd * ( 1 - tc )
V V
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Why MV (E and D) not BV is used to compute WACC? This is because WACC is used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Since the decision is to be consummated at present or in the future, the best WACC factor to compute is the MV.

▶ Reply to This

Permalink Reply by VIVEK P TONDAPURKAR on February 3, 2009 at 12:36am

MV shows the value as per the Current position it is the worth of the company whereas BV is the historical & calculated dvalue . it is just the Notional value in a way . hence MV is considered while calculating the Debt Equity Ratio for WACC

▶ Reply to This

Permalink Reply by Mahinda. D. N. Vito on February 3, 2009 at 8:37am

Hello,
Allow me to shed some light from a different perspective. as you are aware gearing is considered in WACC. the gearing ratio is the principal measure of a firms capital structure, and exposure to financial risk. Because the returns demanded by investors are measured relative to their investments in the firm, then their risk exposure is measured with respect to variations in their returns based on the market values of the securities they hold, there for in all capital structure decisions, of which the cost of capital is part,we refer to market gearing = MVd/(MVe+MVd) or MVd/MVe, as opposed to book gearing which is based on outstanding debt and equity in the balance sheet.
i hope i hit home or near there

▶ Reply to This

• ‹ Previous
• 1
• 2
• Next ›
• Page