Can you correctly state your company's WACC?

This time it's a bit long. It's about finance. It's an area that corporate planning cannot avoid, but many people stop at "knowing it vaguely." That's why I'm writing this. If you read it through, the way you see investment decisions should change.

If I asked myself this back when I was at a JTC (Japanese Traditional Company), honestly, it would have been questionable.
I know the formula. I understand the concept.
But if asked to immediately answer "the company's WACC at this very moment" with the rationale included, I wouldn't have been confident.
There are more corporate planning professionals like that than you might think.

"Knowing" and "being able to use" are different things

The number of people who know the term WACC has increased.
That's because financial training has become more comprehensive.
But knowing it and being able to calculate it correctly are different things.
Furthermore, being able to calculate it correctly and being able to use it for decision-making are two completely different things.
What is happening in the field is a state of being stuck at one of these three stages.

3 patterns of "WACC misuse" I have seen

① The CFO's statement from 3 years ago is still alive

The figure mentioned by the CFO during the formulation of the medium-term plan three years ago is still circulating within the company.
No one has updated it.
Even if the interest rate environment changes drastically or the company's borrowing structure changes, the number remains the same.
The idea that "we look at an 8% hurdle" is disconnected from reality.

② Using beta "vaguely based on industry averages"

If asked about the meaning of the beta value, most corporate planning staff can answer.
"It is an indicator of how sensitive a company's stock is to the movements of the market as a whole."
That is the textbook answer.
But they get stuck on the next question.
"So, do you know what our beta is right now?"

If it's a listed company, it's still okay.
Because there is stock price data, you can actually calculate your own beta.
Specifically, it's like this.
Line up the weekly returns of your company's stock and the returns of a market index like TOPIX.
Take data for the past 2 to 5 years.
Divide the covariance of those two by the variance of the market return.
That is the beta.
It comes out with one Excel SLOPE function.

However, there is a pitfall here too.
The number changes depending on how you set the period.
Whether you calculate it over 2 years or 5 years, the beta will naturally shift.
If you calculate it over a period that includes the COVID-19 pandemic, the beta is likely to rise because it includes a period of high volatility.
It also changes depending on whether it is weekly or monthly.
Generally, 2 to 3 years of weekly returns are easier to use in practice.
However, this is not the absolute correct answer either.

The problem is when calculating the WACC for an unlisted company or a business subsidiary of a listed company.
Since there is no stock price, beta cannot be calculated directly.
That's where the approach of "using the average of industry peers" comes in.
This itself is not wrong.
It is a legitimate method used in practice.

The problem is when you do it "vaguely."
The way you choose comparison targets becomes sloppy.
Without a clear definition of "industry peers," you just line up three companies you happen to know.
Even if the business composition of those three companies is completely different from yours, you just take the average and finish.

Furthermore, you forget to adjust for leverage.
The beta of other companies is a "levered beta" that reflects that company's capital structure.
Your company's capital structure is different.
Therefore, you need to revert it to an unlevered beta and then re-lever it using your company's D/E ratio.
There are many cases where this step is skipped.

The correct procedure is as follows.
・Narrow down comparison targets by business content and revenue structure
・Convert each company's beta to unlevered (removing the impact of debt)
・Take the average of those
・Re-lever it back using your company's D/E ratio

It takes effort.
But if you skip this effort, the beta figure will be off by 10% or 20%.
The impact on WACC is not small.

③ Debt cost remains pre-tax

This is subtle, but it definitely messes up the calculation.
The formula for debt cost looks simple.
Interest expense divided by interest-bearing debt balance.
With this, you conclude, "Our borrowing cost is 2%."

But you shouldn't stop there.
Debt has a tax shield effect.
Since interest expenses are tax-deductible, the actual cost should be considered after tax.
If the statutory effective tax rate is 30%, a 2% debt cost becomes 1.4% after tax.

　After-tax debt cost = Pre-tax debt cost × (1 - effective tax rate)

Many people know this.
But when you look at the actual calculation sheet, it is sometimes used as pre-tax.
That's because they "feel like they've calculated it."
Once you've done the calculation of interest expense divided by interest-bearing debt, you feel like you've done your job.
That's where the thinking stops.

Why does misuse not disappear?

There are two structural problems.
One is that the "situation where WACC is used" and the "situation where WACC is calculated" are separated.
The people who use WACC in investment decision-making are the business divisions or senior corporate planning staff.
But the ones calculating it are young staff, or sometimes no one is calculating it at all.
The numbers are taking on a life of their own.

The other is that "no one is troubled even if it's wrong."
Whether the WACC is 8% or 10%, if the NPV of the investment project is in the black, it will pass.
If it's in the red, it won't pass.
When it's used to that extent, there is no incentive for anyone to improve accuracy.

3 things corporate planning should do right now

① Recalculate WACC every year

There is nothing more dangerous than the phrase "it should be the same as last year."
The elements that make up WACC will all move if left alone.

First is the cost of debt.
If the interest rate environment changes, the borrowing interest rate changes.
The composition also changes at the time of refinancing.

Next is the cost of shareholder equity.
If you calculate it using CAPM, the risk-free rate changes.
Government bond yields move every year.
Beta also changes if the industry environment or your company's business composition changes.

Furthermore, the capital structure itself changes.
If you increase capital, the ratio of shareholder equity rises.
If you increase borrowing, the ratio of debt rises.

With this many variables, continuing to use numbers from three years ago is just negligence.
The timing for updating is realistically after the financial results.
Once updated, get approval from the CFO or the person in charge of finance.
Make it the "WACC used by the company" rather than "numbers calculated independently by corporate planning."
This extra step completely changes the reliability of the numbers.

② Summarize and share the calculation logic on a single A4 sheet

There is no point in sharing only the WACC number.
If "why it becomes that number" remains a black box, no one can question it, and no one can update it.

The items to be put on the sheet are simple.
・Risk-free rate: What year government bond are you using?
・Beta: What company/period data are you using?
・Market risk premium: What data are you referencing?
・Debt cost: How are you calculating it, and what tax rate are you using?
・Capital structure: Is it book value-based or market value-based?

If the rationale is visible, you can have a discussion like, "Isn't this assumption too conservative?"
Conversely, if the rationale for a number is not visible, no one will notice if someone conveniently rewrites it.
Or no one will be able to touch it, and it will just age.

What's important is to create a state where "anyone can reproduce it."

③ Do not confuse WACC with hurdle rate

WACC is ultimately the "cost of capital."
The weighted average of the returns required by shareholders and creditors.
In other words, it is the minimum rate of return that the company must earn to survive.

On the other hand, the hurdle rate for investment decisions is a different thing.
The hurdle rate is the figure obtained by adding the "risk premium specific to that investment" to the WACC.
For a new business, the markup will be larger because the uncertainty is high.
For equipment renewal in an existing business, the markup can be small.
In other words, the hurdle rate should ideally change for each investment project.

However, in the field, it is like this.
"Our WACC is 8%, so if the IRR exceeds 8%, we'll pass it."
This is not wrong, but it is crude.
They are judging both high-risk new businesses and low-risk existing line enhancements with the same 8%.

What happens as a result?
High-risk projects become easier to pass.
Low-risk, solid projects are rejected for being "barely 8%."
The entire portfolio becomes distorted without anyone realizing it.

To summarize (the numbers are examples).
・Equipment renewal for existing business → WACC + 2-3%
・Business expansion into adjacent areas → WACC + 4-5%
・New business/new market entry → WACC + 7-10%

What is important is to have the organization hold the awareness of "not measuring all projects with the same yardstick."
Companies that reply "Aren't they the same?" when asked about the difference between WACC and hurdle rate have poor investment decision design.

Do not speak in "certainties"

The cost of capital is the minimum line of return that the company promises to investors.
Making investment decisions while leaving that ambiguous is like running a marathon without knowing where the finish line is.
If corporate planning speaks about WACC in "certainties," then all of that company's investment decisions are running on "certainties."