M&A Fundamentals – Working Average Cost of Capital (WACC)
The Cost of Capital is a key input to the DCF Present Value models that an M&A professional will use to calculate both the intrinsic and the strategic value of an M&A target. We explore how M&A professionals use DCF Present Value models in business valuation in another article in this M&A fundamentals series: M&A Fundamentals – The DCF Present Value Method of Business Valuation.
The WACC calculation is the technically correct method to arrive at the discount rate for an M&A valuation model. It represents an average of the cost of capital from all sources, including shares, preference shares, bonds, loans and other forms of debt. It expresses in one number the return both equity investors and providers of debt expect from their investment in the company.
It is important to use a weighted cost of capital as in most situations where an M&A professional is using a DCF present value model for business valuation they will be calculating the enterprise value of the M&A target. That is the value to both equity and debt providers of capital. The concept of enterprise value is explained in another article in this M&A fundamentals series – M&A Fundamentals – Enterprise Value.
The discount rate is the required rate of return on the investment – in this case the acquisition of an M&A target. If an M&A target cannot at a minimum generate the required rate of return, and ideally exceed the required return by a generous margin, it is not a good use of shareholder’s money.
How Do We Calculate the WACC for an M&A Transaction?
The formula to calculate the working average cost of capital (“WACC”) for a company is set out below:
Diagram 1: Formula for Working Average Cost of Capital (WACC)
WACC = Working average cost of capital
Ke = Cost of equity
Kd = Cost of debt
MVe = Market value of equity
Mvd = Market value of debt
In plain English the WACC is the currency value of the implied return paid on equity plus the interest paid on debt, divided by the market value of equity plus debt.
For a large corporation the bulk of its capital structure will be shares traded on a stock exchange, and corporate bonds traded on a bond exchange. In the WACC calculation it is important to note that for both debt and equity, the rate of return will be the return on the traded price of the security, not on the price at which the security was issued.
We explore the cost of equity (Ke) and the cost of debt (Kd) in two further posts in this M&A fundamentals series:
M&A Fundamentals – Calculating the Cost of Debt
The Capital Structure of a Limited Company
The capital structure of a limited company is made up of debt and equity. Investors expect a return for providing funds to the company. The return they expect depends upon the perceived level of risk. Diagram 2 below explains the two sources of capital and how they differ in terms of risk and returns to the investor.
Diagram 2: Sources of Finance
The treasury function of a large corporation should create a finance structure appropriate to the funding needs and risk profile of the enterprise.
If a company is in a cyclical industry treasury might prefer a structure with a high proportion of equity – dividend distributions can be reduced in the down cycle – but the corollary is a higher cost of capital.
If a company is in non-cyclical, stable growth sector treasury might prefer a high level of debt. This will reduce the cost of capital.
In the real world both debt and equity can be a complex mix of different securities, each with its own blend of security ranking and payment protections. We explore the different types of debt and equity instruments in another article in this M&A fundamentals series. M&A Fundamentals – Understanding the Role of Debt and Equity in M&A Transactions.
Cost of Capital for M&A – Own WACC or Target’s WACC?
If you are an M&A professional in a large corporation the treasury or finance function will provide a WACC figure to be used for investment decisions. If the M&A target is in a sector and region closely related to the M&A buyer’s own business, the M&A professional can safely use the corporate WACC in the business valuation. If the M&A target is in a sector or country with a different risk profile, the M&A professional should calculate a WACC for the specific target.
This topic is tackled in more detail in our Advanced Business Valuation Training Course.
About The Merger Training Institute
We provide practical, in-career mergers and acquisitions training for boards, executives and professionals in global corporations.
Our short, intense M&A courses are designed for executives needing to understand best M&A practice or adding new M&A responsibilities to their existing roles.
The courses are taught by tutors with hands-on M&A experience gained as part of corporate management teams. As well as being academically rigorous they are rich with case studies and real-world examples based on our tutor’s practical mergers and acquisitions experience.
Our course participants come from a wide range of industries and roles including general management, business development, strategy, marketing, finance, human resources, operations and legal.
Our Mergers and Acquisitions Training Courses
Core Mergers and Acquisitions Skills Training Course
The Core Mergers and Acquisitions Skills programme (M&A training course) is a three- day programme that teaches all the commercial and technical skills you will need to confidently lead or support a successful M&A transaction.
Our expert tutors guide you through the M&A process from strategy and deal origination to valuation, due diligence, deal structuring, contract negotiation and post-merger integration.
M&A Due Diligence Training Course
The M&A Due Diligence Training Course is a two-day programme that offering a solid grounding in the techniques used by some of the world’s most successful companies to assess risks, evaluate synergies and confirm the strategic fit of an M&A target. The course is designed specifically for executives involved in corporate M&A.
Successful Post-Merger Integration Training Course
The Successful Post-Merger Integration Training Course is a two-day programme that provides a solid grounding in the post-merger integration techniques used by some of the world’s most successful companies to deliver value from their M&A transactions.
Across the two days of the course you move from the key decisions made in the pre-deal phase, through the critical first 100 days and on to full synergy delivery. The course covers the post-merger integration issues most likely to arise in each business function and the most important business processes.
Advanced Business Valuation Training Course
The Advanced Business Valuation training course is a two-day expert level business valuation training course that teaches participants how to prepare robust business valuations in the context of a corporate M&A transaction.
Our expert tutors move you past the stage of plugging numbers into a standard spreadsheet and help you explore how risk, synergies and the quality of the target company might impact its value.