WACC calculation

[Pradeep Melchis]

Hi all,

      Had a nagging doubt on WACC calculation. Can someone throw some light on why, retained earnings would not be considered a part of equity, while calculating the weights for Debt and Equity part?

My thinking was -

• First, Retained earnings is also a part of equity which the shareholders have allowed a company to retain so that they generate excess returns over the cost to finance it.
• Even in the calculation of D-E ratio, we include retained earnings as a part of equity

Request some article as well which gives some info on the same.

Regards

Pradeep

[Sivaprakasam p]

Hi Pradeep,

Equity has been to mean Networth of the firm represented by
Shareholders Equity + Retained Earnings, which is also represented by
Sum of all Assets - Outside Liabilities. Hence DER is essentially
Debt/Networth. Likewise, for calculating cost of equity, we use CAPM
model usually n the risk premium factors in retained earnings too. And
cost of equity is just the return as a percentage expected out of
equity (Networth) n hence in absolute terms say a portion of retained
earnings is knocked off it reduced the return only to the extent of
earnings potential and not in absolute terms. PFA an excel that
details the entire balance sheet n pnl for all purposes. Very useful.
Go thro all sheets..

Regards,
Sivaprakasam P

On 11/16/09, Pradeep Melchis <amp...@gmail.com> wrote:
> Hi all,
>
> Had a nagging doubt on WACC calculation. Can someone throw some light
> on why, retained earnings would not be considered a part of equity, while
> calculating the weights for Debt and Equity part?
>
> My thinking was -
>
>
> - First, Retained earnings is also a part of equity which the
> shareholders have allowed a company to retain so that they generate
> excess
> returns over the cost to finance it.

> - Even in the calculation of D-E ratio, we include retained earnings as a

[Pradeep Melchis]

Thanks for the prompt reply Siva. One sound argument in favour of what Siva explained is that the Market Value of Equity would factor in the retained earnings. Hence, when we calculate the weights for WACC, we need not add Retained Earnings.

Insights - Vishnu  n Siva.

Views of others are most welcome.

Regards

Pradeep

[Raj Smiling]

Guys,

WACC is calculated with many assumptions in a simplified form in our text books. Retained Earnings have a cost involved with them and this is called as "Cost of Retained Earnings" which is defined as the return that the company should make to justify retaining the money & plowing it back in business, rather than paying back to the shareholders. The cost of equity should itself be a weighted average of Cost of RE & Cost of issuing common stock. But for simplification, all our text books does not consider retained earnings to calculate WACC. Also, note that you can get money into business either from RE or by issuing new common stock. hence, the weighted avg of these 2 is suggested as "Cost of Equity".

regards,
Surenderan E

[Selvarajan]

Pradeep,

Jus give us more info on the basis of the argument - cost of reatained
earning is zero.. Like the author's source, supporting statements,
etc!


Regrads,
Selvarajan.

On Nov 16, 5:14 pm, Pradeep Melchis <amp...@gmail.com> wrote:
> Hi all,
>
>       Had a nagging doubt on WACC calculation. Can someone throw some light
> on why, retained earnings would not be considered a part of equity, while
> calculating the weights for Debt and Equity part?
>
> My thinking was -
>
>    - First, Retained earnings is also a part of equity which the
>    shareholders have allowed a company to retain so that they generate excess
>    returns over the cost to finance it.

>    - Even in the calculation of D-E ratio, we include retained earnings as a

[Ankit Jain]

Hey Guys,
@ Suren: I would second Melchis on this. All your arguments, though
very much true is not making me understand the taking of wgt. average
cost of Eq. and RE coz as I can recall, Cost of RE is nothing but Cost
of existing Equity. Only cost of new equity is something which is
different(which is calculated accordingly if required for that level
of total capital requirements). Weights are taking into account RE as
well as Sh. Cap as the mkt. value encompasses everything. So, Melchis'
argument seems to be more prudent.
I am sure you might as well wanna share any of the evidence you might
have on your POV. I am sure that would help us understand your POV
better.
@Selvarajan: I don't see Pradeep saying cost of RE being Nil, welcome
to correct me otherwise. To my knowledge, he just said weights of RE
is embedded in the market value of Equity (Share Cap + R&S). I hope it
helps.

Thanks & Regards
Ankit

[Pradeep Melchis]

Hey was just expressing the views of Siva and Vishnu. Am still not convinced as to why we shouldn't include R.E. in WACC calculation. We aren't using WACC for the new equity to be raised. In fact your Market share price just adds a premium to your existing shares. I somehow, find it difficult to ignore RE. Because WACC calculation is not for fresh Equity alone. 

@Selva: RE will not have zero cost. It must be Cost of Equity only.. If it is cost of Equity then WACC ( which is the weighted average of both D and E) should contain RE as well.

Regards

Pradeep

[Surenderan E]

Guys,

As said by Melchis, even I find it difficult to ignore RE. When you say you want to raise capital it can come from two forms apart from debt right:

1. Issue new equity shares
2. Money from your RE

Cost of equity will always be higher then Cost of retained earnings by few considerable % points because there are floatation/issue costs associated in getting new equity whereas you can use RE without any additional cost.

Retained earnings has an opportunity cost associated with it for shareholders as its their income that is foregone and used in business & it can be calculated in the following ways:

http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/cost-of-retained-earnings.asp

http://www.investopedia.com/terms/w/wace.asp

As requested by Ankit, I am sending one of the sources where I came across my point.


http://books.google.co.in/books?id=GF_EO-ZxyM4C&pg=PT502&lpg=PT502&dq=cost+of+retained+earnings%2BWACC&source=bl&ots=3qH8XzmfUy&sig=fXQE8-Y1kh3uwdyBynUKQfihlo4&hl=en&ei=M3cBS4rCLYzm6gPisYntCg&sa=X&oi=book_result&ct=result&resnum=7&ved=0CCUQ6AEwBg#v=onepage&q=cost%20of%20retained%20earnings%2BWACC&f=false


Hope I have made sense now!! ;) Pls do correct me if you find any thing wrong.... have a great day :)

regards,
Surenderan E

[Selvarajan]

Ankit,

Pradeep started discussion asking "why RE would not be part of cost of
equity", which means RE comes with no cost. This is provided the fact
we dont generally have cost of RE for a company!

Now some viewpoints have been put forth as there could possibly have
been a 'cost of RE' which is less costlier than equity. But logically,
reinvesting in the same business is with the belief that it would
generate >WACC returns. This makes RE a part of equity!!

Cheers :)

Pradeep/Siva,

The logic is perfectly fine! If we take Market Value, it factors in
the extent of RE!

The question is, what would happen if take the other route of
calculating WACC through share capital and RE?

If you ask me whats the significance of the question, pls look at
this :
Suppose that I'm going to 'value' a business entity. If I take the MV
of equity and proceed further, it would finally fetch me(or at least
drive towards) the result that "the market value of equity is its
intrinsic value"!! Isnt it? It goes against the objective of the
valuation!! :)

PS - The crux of the problem is similar to one that is attributed to
Relative Valuation method.

Regards,
Selvarajan.

[Ankit Jain]

Guys,
I think the discussion is shifting from weights of RE NOT being
considered to cost of new Equity being different. Getting back to the
topic, the contention here is why don't we take weights of RE to
calculate WACC. The answer is that we don't use Book Value of Capital
and Debt as weights, had it been the case Pradeep's doubt was
relevant
( a rectification in that would be to take Equity Shareholder's fund,
which includes RE, as its weight). However, pragmatic use is of
market
value of Eq. Shares, which reflects nothing but market perception of
"Eq. Shareholder's funds", as their weights.
The doubt can be whether weights of New Equity is taken to find WACC.
The answer lies in MCC i.e. Marginal cost of capital according to
which if the additional capital required is not satisfied by RE
alone,
we have to raise new equity, the weight of which will surely be
considered multipied by its cost.
In a nutshell,
1. Weights of RE is always considered which is nothing but a part of
shareholder's fund, the market value of which is considered as
weights.
2. When RE is not enough to satisfy the Equity Requirements, new
Equity is issued, the weights of which are taken along with its cost
of capital separately and adds upto WACC.
Thanks Surenderen for sending me that link, which too stands
testimony
to my argument.
Regards
Ankit

[Surenderan E]

Adding on to my previous post,

Attached a doc on Cost of Capital....Pls refer Chapter-2 of the doc in page 8. There's a fully solved example on WACC considering the retained earnings :)

[Pradeep Melchis]

Hey Guys, 

       Now that we've got some clarity in terms of using RE for WACC calculations- As per the article that Suren sent

• WACC calculations should include RE as well as the MV of Equity
• Infact the cost of equity should we the weighted average of the Cost of Equity (whose MV is used) and also the cost of RE

Lets move on to the two questions posed by Murugavel sir -

- what is an acceptable assumption for cost of equity for a new firm in India ? why?

- what is an acceptable assumption for risk free rate in India ? why ?

 

Will try to get back with answers. Others also do pitch in!

Regards

Pradeep