In performing a business valuation, deciding whether to use the weighted average cost of capital (WAAC) or a build-up method depends on the circumstances. Both methods are appropriate in valuing a business.
The WAAC represents the rate of return an investor expects that includes all investors, debt, and equity. It can be useful when the company has:
- A Complex Capital Structure and you need to distinguish the different rates of returns for costs of equity and several types of debt.
- Consideration of an acquisition and the buyer expects to pay off the debt and equity and refinance the entire debt and equity structure.
- The objective is to value the equity of a business. The value of the Market Value of Invested Capital (value of debt and equity) is appropriate when a company is highly leveraged to understand the equity separate from the debt holders.
- Capital Projects are situations where the WAAC can provide answers to what could be available to finance capital projects. This would be based on debt capacity.
The Build-Up Method is another way to estimate the cost of capital when valuing a privately held business. It is commonly used for small, privately held companies and involves “building up” various risk premiums of market rates of returns. The Build-Up Method is appropriate when.”
- Small privately held companies where market data may not be readily available.
- When there is no comparable market data to determine beta or market risk premiums.
- Unique risk factors that can be accounted for in a more customized risk premium addition.
- Early-stage companies that do not have stable capital structures.
Some common mistakes when calculating the WAAC and the Build Up Method
WAAC
- Using the historical cost of debt instead of current market cost of debt. If a buyer is going to retire the debt and refinance, they will want to know what the current debt structure looks like.
- Failing to account for the tax deductibility for the interest expense.
- Using the average tax rate vs the marginal tax rate can lead to incorrect calculations.
Build-Up
- Using a risk-free rate that does not match the time horizon, for instance, using a 20-year bond when the investment horizon is 10 years.
- Using a general equity risk premium when more specific content is available.
- Over reliance on subjective information without justification.
The choice of how a discount rate and/or capitalization rate is going to be calculated can be a difficult decision, but choosing an experienced business valuation analyst will go a long way.