- August 23, 2020
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Understanding The Risks and Cost of Capital in Business Valuation
In valuation, the topics of risk and capital cost are crucial, integral, and laden with misunderstandings. These misunderstandings can lead to strategic blunders. For instance, when a firm borrows capital to fund an acquisition and employs only the cost of debt to the target’s cash flows, it might inevitably overvalue by two times the target’s value. Conversely, when a company attaches an arbitrary risk premium to a target’s cost of capital in an emerging market, it could undervalue the company by half. In this post, I provide insights on understanding the risks and cost of capital in business valuation
A firm’s cost of capital is decisive for ascertaining value creation and for assessing strategic decisions. It is the rate at which you discount future cash flows for a business. It is further the rate you compare with the return on invested capital to conclude if it is generating value. The cost of capital combines both the time value of money and the risk of investment in a business.
Cost of Capital Is an Opportunity Cost
The cost of capital is not a cash cost but an opportunity cost. To substantiate, when one firm acquires another business, the option might have been to return that cash to stockholders, who could reinvest it in different companies. So the cost of capital for the acquiring firm is the price investors command for carrying risk—what they could have made by reinvesting the returns in other ventures with comparable risk.
Likewise, when valuing specific business units for strategic decision making, the correct cost of capital is what a company’s investors could expect in other similarly risky projects. The focus is that investors’ opportunity cost pushes the cost of capital because the managers leading the firm are the investors’ representatives and have a fiduciary duty to the company’s investors. That’s why the cost of capital get attributed as the investors’ requisite return or expected return.
Managers regularly fail to appropriately incorporate the concept of opportunity cost in conceiving about their cost of capital. Sometimes they confuse up the opportunity cost of capital by connecting various funding streams with multiple investments. For instance, when one firm acquires another, the acquirer might borrow sufficient debt to pay for the whole business. It is fascinating to say that the cost of capital for the acquisition is the debt cost. However, this would be a blunder because the risk of the target’s free cash flows does not match the bondholders’ cash flows. To explain, say Company A is contemplating buying Company B. Both serve in the similar product area with comparable risks. Company A has no debt and an opportunity cost of capital of 8%. Assume Company A can borrow at 4% after taxes. For a target business rising at 3% with $1 billion in earnings and a 15% return on capital, the target would be $80 billion at a 4% cost of capital and $16 billion at an 8% cost of capital. To get an insight into how ridiculous it would be to use the 4% cost of capital, consider that the implied price-to-earnings ratio (P/E) at 4 percent is 80, compared with 16 at an 8% cost capital. Companies expanding at 3% don’t trade at a P/E of 80.
Besides, if you employ the cost of debt to the acquisition, you settle up with a careless situation: Company A’s existing businesses get assigned an 8% cost of capital, and the acquired business gets allocated a 4% cost of capital. Furthermore, the only basis Company A can borrow 100% of the value of the acquisition is that it has additional debt capacity in its current businesses. And don’t neglect that the cost of capital gets defined by the acquired company’s riskiness, not that of the parent company (although their risk profiles expected to be identical if they are in the related industry).
Firms Have Limited Control over Their Cost of Capital
The WACC of large companies is in the range of 7-9%. The scale is minute because investors deliberately avoid placing all their eggs in one basket. The capability of investors to diversify their portfolios means that only non-diversifiable risk influences the cost of capital. Moreover, because non-diversifiable risk further usually strikes all companies in the same industry identically, a company’s industry is what fundamentally drives its cost of capital. Companies in the corresponding sector will have similar costs of capital.
The risks they cannot diversify regularly are those that hit all companies, such as vulnerability to economic cycles. Though, since most of the risks that companies encounter are, in fact, diversifiable, most risks don’t harm a company’s cost of capital. One approach to understanding this in practice is to see the relatively restricted range of P/Es for large companies. Most large companies have P/Es in 12 and 20. If WACC sways from 5 to 15% instead of 7 to 9%, many more companies would have P/Es less than 8x and above 25.
Create Better Forecasts, Not Ad Hoc Risk Premiums
Many large capital projects in politically sensitive countries (standard amongst companies in the mining and oil and gas sectors), risky R&D projects in high tech and pharmaceuticals, and acquisitions of unproven technologies in a broad range of industries bear high risks. The likely returns for such investments are alluring, but what if the projects companies fail? The solution is not to overlook these risks but to explicitly include them in cash flow forecasts, not WACC. The favored method is to generate multiple cash flow scenarios.
It’s not uncommon for companies to increase the estimated cost of capital to show risky projects’ uncertainty. However, they usually unconsciously set these rates at levels that even material underlying risks would not support—and end up refusing attractive investment opportunities. Many don’t recognize that hypotheses of discount rates that are only 3-5% higher than the WACC can significantly decrease estimates of expected value. Adding just 3% points to an 8% WACC for an acquisition, for instance, can reduce its present value by 30-40%.
A more useful method for determining the expected value of a project is to generate multiple cash flow scenarios, value them at the unadjusted cost of capital, and then employ probabilities for each scenario’s value to evaluate the expected value of the project or company.
Employing scenarios has numerous benefits:
- It presents decision-makers with added information. Rather than staring at a project with a single-point estimate of expected value (say, $100 million), decision-makers understand that there is a 20% chance that the project’s value is –$20 million and an 80% probability it is $120 million.
- It helps managers develop strategies to mitigate definite risks because it explicitly highlights the consequence of failure. For instance, executives might create more flexibility into a project by giving options for stepwise investments—scaling up in the event of progress and scaling down in the event of failure. Building such opportunities can significantly enhance the value of projects.
- It recognizes the full extent of potential outcomes. When project advocates present a single scenario, they need it to indicate enough upside to obtain approval and be pragmatic enough to act to its performance targets. If advocates offer multiple scenarios, they can display a project’s full upside potential and realistic project targets they can genuinely commit to while also completely disclosing a project’s potential downside risk.
To avoid adverse strategic decisions, managers must recognize the dynamic relationship between the cost of capital and risk. Risk enters valuation through the company’s WACC, and the uncertainty surrounding future cash flows. As investors can diversify their portfolios, a company’s WACC is, defined by the industry in which it serves. Hence firms should incorporate in their valuations, multiple cash flow scenarios that reflect diversifiable risks than those that alter the cost of capital.