www.futurumcorfinan.com Page 1 Discussion Paper Series: The Net Present Value of The Firm is Equal to The Net Present Value of The Equity Discussions by Using the Paper “Applicability of the Classic WACC in Practice” (2005, by M.A. Mian and Ignacio Velez-Pareja) Note: IVP = Ignacio Velez-Pareja (Associate Professor of Finance at Universidad Tecnológica de Bolívar in Cartagena, Colombia) Karnen : Sukarnen (a student in corporate finance) Karnen I am now on reading a paper with the title “Applicability of the Classic WACC in Practice” (2005) (downloadable from http://ssrn.com/abstract=804764). Just started, on page 5: I am a bit surprised about equation (1) and (2). The authors have put "after-tax WACC" and "before-tax WACC". Sukarnen DILARANG MENG-COPY, MENYALIN, ATAU MENDISTRIBUSIKAN SEBAGIAN ATAU SELURUH TULISAN INI TANPA PERSETUJUAN TERTULIS DARI PENULIS Untuk pertanyaan atau komentar bisa diposting melalui website www.futurumcorfinan.com
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Page 1
Discussion Paper Series: The Net Present Value
of The Firm is Equal to The Net Present Value of
The Equity
Discussions by Using the Paper “Applicability of the Classic WACC in
Practice” (2005, by M.A. Mian and Ignacio Velez-Pareja)
Note:
IVP = Ignacio Velez-Pareja (Associate Professor of Finance at Universidad Tecnológica
de Bolívar in Cartagena, Colombia)
Karnen : Sukarnen (a student in corporate finance)
Karnen
I am now on reading a paper with the title “Applicability of the Classic WACC in Practice”
(2005) (downloadable from http://ssrn.com/abstract=804764).
Just started, on page 5: I am a bit surprised about equation (1) and (2). The authors have put
"after-tax WACC" and "before-tax WACC".
Sukarnen
DILARANG MENG-COPY, MENYALIN,
ATAU MENDISTRIBUSIKAN
SEBAGIAN ATAU SELURUH TULISAN
INI TANPA PERSETUJUAN TERTULIS
DARI PENULIS
Untuk pertanyaan atau komentar bisa
diposting melalui website
www.futurumcorfinan.com
www.futurumcorfinan.com
Page 2
I don't think it is correct to put the thinking into "after-tax" and "before-tax" for WACC. As we
know, it is all about Tax Shield (TS), whether we want to factor it into Free Cash Flows
(numerator) or discount rate (denominator).
As we discussed previously, and as you have enlightened it to me, behind WACC, there is a
strong assumption that "tax is paid in the year it is accrued", which assumption, we do
know, not correct!
I did remember, I discussed this "before-tax" and "after-tax" WACC with you, the terminology
that Peter DeMarzo and Jonathan Berk also used, and you are against it.
On the last paragraph of page 5/21:
“Under certain assumptions we can call the WACC_BT as the WACC for the Capital Cash Flow
(CCF).”
My comments:
1) The authors didn't put any footnote or any reference, what does it mean with "under certain
assumptions"? It is so ambiguous and it is not fair to leave it to the reader to fumble around.
2) I don't think we could refer it WACC_BT (before tax) for CCF. As we both know, Capital Cash
Flow (CCF) has included Tax Shield (TS), and accordingly, to avoid double counting, the
discount rate should not include TS discount rate anymore.
IVP:
Yes! You are right.
The problem of after or before tax is the same as when you say unlevered value of a firm
(V_unleved). In reality, it means with no tax effects. It means with no TS! That is a problem that
makes very difficult to explain the readers when writing a text for a book or a paper.
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And particularly when dealing with CCF! It has debt and taxes embedded in it and yet we say
we discount it with Ku (the unlevered cost of equity) or the "before" tax WACC.
What do you suggest to solve this semantical problem?
Karnen
Ok, we have predetermined debt schedule and the best way to deal with this situation is using
APV (=Adjusted Present Value), in which we separate FCF (hypothetical all equity) and TS, and
we apply discount rate to each part.
IVP
There is no better method. ALL of them yield the same answer.
Karnen
I am wondering which discount rate we are going to use.
You set the assumption about psi and use the one that fits the cash flow
the first part FCF, assuming psi is Ku, then we use Ku - TS/VL_t-1.
the second part, TS, assuming psi is Ku, then we use Ku.
IVP
NO. This formula Ku - TS/VL_t-1 is WACC for the FCF. In the APV FCF is discounted at Ku.
Just that simple. The TS are discounted at the psi you have assumed from the start
Karnen
As I know now, WACC_AT has incorrectly treated the TS in the same year it is accrued, do we
need still use it in the future?
IVP
That is true for the textbook formula, not for Ku - TS/VL_t-1. The idea in this formula is that you
include there the TS whatever the source (interest, adjustment to book equity if adjustment for
inflation are made, exchange losses in debt, dividends as in Brazil (see
http://papers.ssrn.com/abstract=1421509), etc.
When you have fixed or contractual CFD THAT makes the Ke (and WACC) change. You keep
the debt schedule as a given and you adjust Ke and/or WACC by D% or D/E.
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Karnen
The example shown under Tables 8 to 10 and the analysis is pretty much about reminding us
that if we use predetermined debt schedule, WACC_AT that is blindly applied will lead us to
incorrect value. There are strong assumptions behind WACC_AT.
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Page 5
Since the debt repayment will follow certain schedule, it will mean D/V will keep changing from
year to year, and WACC needs to be recalculated each year - iteration, but this is easy to
handle using Excel. I believe the same idea is elaborated as well in your paper "Return to
Basics: Cost of Capital Depends on Free Cash Flow" (2008) (downloadable from
http://ssrn.com/abstract=1281451) that I have had read before.
Upon thinking about iteration and all formulas, this makes me wondering:
We have free cash flow, TS, WACC iteration recalculated and so it is not difficult to get Ku -
working backward. I have not yet tried it, but I will try it tomorrow, will we get different Ku each
period, like different WACC each period?
If we get the same Ku, for example, what does it mean? Is that correct Ku as per "market"? How
to validate this backward-iteration recalculation of Ku to the market rate?
I reworked Table 2, Table 3 and Table 4 of the paper "Applicability of the Classic WACC in