WACC: USING [DEBT MINUS CASH = NET DEBT] OR DEBT?

When you build the discount rate of WACC. The debt you are going to use is Debt or Debt minus Cash (=Net Debt)?

The latter is becoming more popular knowing the fact that many companies now (started this trend is the companies in technology sector, such as Apple, Microsoft, etc.) that maintain large cash balances in excess of their cash operating needs. Much of the reason is for acquisition purposes as part of inorganic growth strategy, which require quick decisions and cash is the currency that is a lot easier to exchange in the negotiation table.

However, I am not really in big favour going for using Net Debt, knowing that:

 

  • In reality, that excess cash is not used for debt repayment and the debt covenant doesn’t require to have early repayment/retirement.
  • The market risk and  yield for cash is different with that of debt.
  • Investors/analysts might be more concerned about the risk underlying the company’s operating business value and not the enterprise value (Debt + Equity – Cash, if we define so).
  • Cash balance is quite fluctuating (and unpredictable) from one period to another period, depending upon the realization and implementation of the execution in the acquisitions.

So I prefer to use “Debt” only as the component in the WACC, and address the risk of Cash separately. Meaning once we have estimated the company’s enterprise value (note: we need to use noncash working capital in coming up with the unlevered free cash flow, or ideally, if possible, to include only operating cash into the working capital), then we could deduct Excess Cash from the Enterprise Value.

Comments from Edward Bodmer (Finance Energy Institute)

I totally agree with you with respect to credit analysis — I don’t think you can call cash as negative debt for things like Debt/EBITDA.

But for equity analysis, consider the following:

One company like apple has billions of cash

Another company with the same operating risks has no cash.

When you measure beta or even volatility of stock prices, the company with no cash should have a higher beta and you can even say that the beta of the equity that you see is the weighted average of the beta on cash (zero) and the underlying asset beta.

If you are using free cash flow without interest income, then you should use a WACC that does not have the downward effect of the cash.

I understand if you disagree with this, but I go even further and say that to get the WACC and beta on free cash flows you should adjust for everything. What I meant is that if you have an associated company that is not in EBITDA (and therefor not in FCF) then you should find the beta of that company (the associated investment) and adjust for the beta like with the cash balance.  You could also try the same with subordinated debt etc.

Comments from Ignacio Velez-Pareja:

Agree with you!

Moreover, I should tell you that all the trash behind net debt is what Aswath Damodaran calls “potential dividends” [Karnen’s Note: the readers who are interested in learning more about Potential Dividends vs Actual Dividends in Valuation of the Firm, could google the papers related to this topic under https://papers.ssrn.com). What does it mean? Well, distributing cash and quasi cash items, but keeping it in the Balance Sheet! I think we have debated this issue before.

Listen, my Golden Rule is that you model what you think it is going to happen in the future. This is, if you repay debt in advance, you reflect that in your Cash Budget and in your cash flows. That simple.

Hence, my answer to your question is use the debt that is in the Balance Sheet. Forget of net debt. If you don’t, then reflect that in the Balance Sheet and the Cash Flows.

When I have lots of invested cash I will have interest income. Remember that equity has a residual income. When I see the Cash Balance, there will be some income at module 5 where you find superavits or zero.When you use the indirect method to arrive to the Cash Flows (CFs), you should start from EBIT+OI (other income that includes interest received). The generation of CF is mainly the operating items (EBIT). I don’t see the need to weigh beta with zero beta. Do you weigh beta with beta debt? Of course not!

I agree with you, except that equity value is PV(CFE at Ke) or PV(CCF at Ku)-Debt. The cash on hand is part of the equity value. I don’t follow you when you define EV subtracting cash. EV is D+E, no more, no less.

What do you think?

[TO BE CONTINUED]

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