WEIGHTED AVERAGE COST OF CAPITAL

Weighted Average Cost of Capital (WACC)



Weighted Average Cost of Capital (WACC)

Introduction

Henkel is manufactures cosmetics, toiletries, laundry and home care products. Co. maintains three business sectors: Laundry and Home Care, Cosmetics/Toiletries, and Adhesive Technologies. The Laundry & Home Care business sector is globally active in the laundry and home care branded consumer goods business. The Cosmetics/Toiletries business sector is active in the Branded Consumer Goods business area with Hair Cosmetics, Body Care, Skin Care and Oral Care, as well as in the professional Hair Salon business. The Adhesive Technologies business sector comprises five market- and customer-focused strategic business units.

Figure 1: Henkel's Brands Names (Henkel AG & Co, 2013)

There's an old story in England about the passenger arriving at Euston railway station asking a porter how to get to Leeds only to be told 'you can't get there from here'. Obviously you can get anywhere from anywhere, the correct answer is that there's no direct route or it is difficult to get there from here. It seems that choosing between different valuation methods gives rise to the same problem. While conceptually there is one correct value for a firm or project, in practice there are multiple ways of calculating it. As a result the important question is which valuation technique offers the most direct route, that is, the easiest and most accurate implementation and how can you check the resulting value against other models.

In this respect, Ruback (2002) has recently proposed the Capital Cash Flows (CCF) method with the claim (p. 21) that 'in many instances the CCF method is substantially easier to apply and, as a result, is less prone to error'. In general this claim significantly overstates the advantages of the CCF approach and it is one objective of this paper to show that the CCF method in general offers no advantages over the traditional weighted average cost of capital (WACC) approach. However, more important this paper shows the route from the CCF valuation to the WACC as well as the route from the WACC to the CCF and other adjusted present value (APV) applications.

The prior discussion has been in the context of a target or optimal debt ratio in valuing perpetuities. This is consistent with Graham and Harvey (2001)'s survey results that indicate that most companies have target debt ratios. As I showed above when there is a target or optimal debt ratio, both APV and CCF collapse to the standard WACC valuation. However, most APV proponents have placed the advantages of APV and CCF in the context of highly leveraged transactions (HLTs), where the debt ratio varies through time. This raises the question can we get from an APV HLT valuation to a WACC valuation with fixed debt levels?

This simplified method assumes that the ordinary stock dividend is constant and that the nominal value of bonds, ordinary, and preferred stock is equal to their market value. The WACC is used to discount the cash flows when the net present value (NPV) ...