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Valuation & Capital Structure (WACC)

Valuation & the Capital Structure (WACC)


From June until August 2019 I have written 6 blogs on business valuation and financial modelling in order to calculate enterprise value. These blogs are still available, you can find the links of the blogs at the very end of this blog.


In the upcoming months, I will write several blogs on the so called “Cost of Capital” that is used in business valuation.


I got inspired to do this after reading the book: “The real cost of capital: A business field guide to better financial decisions” (2004). The book is written by Tim Ogier & John Rugman & Lucinda Spicer. I really recommend any Corporate Finance professional to read this book, since it is so practical and well-grounded in theory!


Blogs in this sequence that I have published already (with the links);


Article 1: Valuation & Betas (CAPM)


Article 2: Valuation & Equity Market Risk Premium (CAPM)


Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)


Article 4: Valuation & the cost of debt (WACC)

In this fifth one in the sequence I will talk about the “capital structure” to be used in the WACC (weighted average cost of capital).


Consultant & Trainer: Joris Kersten


I am an independent M&A consultant and Valuator from The Netherlands.


In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world. This at (investment) banks, corporates and universities.


Also I provide inhouse training on request and I have two open training programs in business valuation in my home country The Netherlands.


At the very end of this blog you can find all information about my open training programs.


Introduction: Capital structure


In the previous blogs I have discussed the cost of equity and the cost of debt.


In order to complete the weighted average cost of capital (WACC) we need to know the weights for the cost of capital components (debt and equity), so we need to find a capital structure to use.


Of course we can start with the current capital structure of the company to value, but please be careful, you need to use “market values” here. So the market value of equity, and the market value of debt.


But this current capital structure is sometimes not representative for the future financing structure.


And with private companies, we do not know the “market value of equity” since this is what we are calculating with the WACC. So we have a “chicken & egg” problem here.


With using a target, or optimal, capital structure we remove the “circularity” between the cost of capital and valuation.


Because the market value of equity determines the capital structure (on market values), which in turn determines the equity beta and the cost of equity, which in turn determines the market value of equity.


Before we get into this in more detail, let’s first discuss capital structure itself, and to what extent it influences the value of companies.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Does capital structure matter?


In the Nobel prize winning work of the famous Franco Modigliani and Merton Miller of 1958 (MM), the financial economists questioned whether the source of financing mattered.


They challenged the way of thinking at that time by suggesting that the value of an investment only depends on its expected cash flows and the cost of capital. And that this was entirely independent on how the investment was financed.


This does not sound very intuitive since debt is almost always cheaper than equity. So equity holders demand almost always a risk premium that higher than the margin debt holders require.


So why would MM have argued that when a firm increases its proportion of debt would not reduce the cost of capital, and subsequently increase its value ???????


The reason is that as a firm obtains more debt, both debt and equity become more risky, and the costs of both debt and equity rise.


In my previous blogs we found that financial leverage increases the size of an equity beta, so leverage increase the cost of equity calculated with CAPM.


And MM proposed that the expected return on (or cost of) equity rises in line with the debt to equity ratio.


In my last blog on the “cost of debt” we also found that debt margins are related to credit ratings. And credit ratings are calculated according to financial characteristics of an investment.


So an increase in the amount of debt in a company will result in worse “financial ratios”, and this will lead to a lower credit rating. And a lower credit rating will lead to a higher debt margin, so a higher cost of debt.


Summarized, when a company gets more debt, cheaper debt replaces more expensive equity. BUT at the same time both the cost of equity and the cost of debt increase.


In the purest version of the MM theory, these two effects exactly offset each other, and the WACC is indifferent to the debt/ equity ratio.


After this theoretical discussion, now let’s jump back to the real world.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Capital structure in the real world


In the real world, when tax is taken into account, the cost of capital falls as the debt/ equity ratio increases. This because in the real world, the more a company borrows, the more tax it saves.


When tax is taken up in the MM theory it shows that firms maximize their value by taking up as much debt as they can.


But this is also not possible in the real world, and this is also not how managers behave.


Managers need to carefully think out their levels of debt, and they might need some “slack”, this for example to execute on opportunities or to act as a buffer when the economy is going down.


And in reality, as debt increases, the risk of bankruptcy will also become bigger. This risk is non-linear to the level of debt and difficult to measure.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Optimal capital structure


The relationship between the WACC and level of debt in the real world is as follows:


WACC falls with taking up more debt.


This because the lower cost of post-tax debt and despite the increases in the costs of both debt and equity.


But beyond a certain point (the optimal capital structure), the WACC will start to increase again, because of negative effects of the debt on the cost of equity and cost of debt.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Issues with an optimal capital structure


The key issues in choosing an optimal capital structure contain taking the effect of the level of debt on both the cost of debt and cost of equity into account. This by also taking the tax relief of debt into account.


But this is theory, and this is a little more complex in real life. Because the relationships between gearing with both the cost of debt and equity are not 100% clear and known.


So in practice, debt levels are set by management on several factors, and some of these factors have more to do with perception than actually hard numbers.


Some examples of these factors:


Example 1

If capital markets were efficient then a company that wishes to invest in a value enhancing new venture would be able to arrange financing for this.

But because of capital market imperfections, capital is not always available, so companies like to take up “slack” on their balance sheets in order to execute on opportunities that emerge;


Example 2

Managers may be reluctant to increase debt to a optimal level for a number of reasons. For example because this puts more pressure on them to deliver strong results (since debt payments need to be met, and dividends not).

Or because more debt increases bankruptcy of their companies, which would take away their jobs;


Example 3

When companies raise large amounts of debt, for example in a Leveraged Buyout (LBO), there is some evidence from US market studies from the ’90 on “predatory pricing”.

This means that competitors are fighting highly leveraged companies on price, in order to push them out of the market, because they have no “slack”. For these “attacks” managers could decide to not gear up with debt to the optimum;


Example 4

On the other hand, if despite risk, management decides to take on extra debt, this might suggest to investors that managers are confident about the financial strength of the company.

And it may also suggest that this debt will discipline the managers (since payments of interest and principle need to be made). This is called “signalling theory”.

The above examples just show the complexity of determining what the optimal capital structure is.

But we steel need to pick one! And we can do this with:

-Industry benchmarks, and,

-Fundamental analysis.

Let’s take a look at both!

(Tim Ogier, John Rugman, Lucinda Spicer, 2004


Choosing capital structure with: Industry benchmarks


Within an industry it is likely that there is a certain range of debt levels for the companies in the industry.


It would be possible for a company in the industry to be temporary “under levered”, but capital markets should provide incentives for these firms to “lever up” since they are failing to take advantage of opportunities to increase value.


And “over leveraged” firms will have an incentive to restructure to “normal levels” because they become to risky.


So often is believed, that for an industry, the average level of gearing is close to the optimal level.


This because there is a “cash flow variability” associated with a certain industry, so their capital structures must be are optimally built for that.


So it is important to pick the right industry benchmark as the level of debt in the capital structure vary widely across industries.


These differences of capital structure between industries can be attributed to:

-Different degrees of revenues cyclicality;

-Different growth potentials;

-Varying fixed costs of operations, etc.


And remember that companies in industries with less systematic risk, which shows from a low asset beta, can in general take on higher debt levels in their capital structure.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Choosing capital structure with: Fundamental analysis


The alternative to the average debt level of industry benchmarks is fundamental analysis.


Here you need to analyse projected cash flows of the business in order to check how much debt it can support.


Financial models can be constructed which can simulate the performance of a business at different levels of gearing, calculating the:

-Resultant cost of equity;

-Resultant cost of debt;

-Resultant firm value.


This in order to explore what level of debt in theory maximizes the value of the company.


Such models use hard market information on debt margins, the probability of bankruptcy etc.


But they may not fully reflect the effects of softer factors such as “signalling” and management desire to keep a little war chest for future instant opportunities.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Sources used for this blog


· The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer. 9780273688747.

This book is fantastic and very practical, just a pleasure to read for every investment professional. Highly recommended! 😊


Next blog next week


In hope you liked this blog on the “capital structure” to be used in the WACC. 😊


In my next blog, next week, I will talk about the “international WACC” and “country risk”.


And when you have any questions in the meantime do not hesitate to contact me on:


Training Calendar on Business Valuation of Joris Kersten:


In case you like additional in class training:


In my home country The Netherlands, and abroad, I provide open training programs in “Business Valuation” and “Financial Modelling”.


The next sessions are given below:

1. Business Valuation & Deal Structuring (6 day training): 18, 19, 20, 21 and 23, 24 March 2020 @ Uden in the South of The Netherlands;

2. Financial Modelling in Excel (4 day training): 20, 21, 22, 23 April 2020 @ Uden in the South of The Netherlands;

3. Financial Modelling in Excel (5 day training): 2, 3, 4, 5, 6 February 2020 @ Riyadh in Saudi Arabia.


All info on these open training sessions can be found on:


And 130 references on my training sessions can be found on:


Trainer & Consultant: J.J.P. (Joris) Kersten, MSc BSc RAB


· 130 recommendations on his training can be found on:

· His full profile can be found on:


J.J.P. (Joris) Kersten MSc BSc RAB (1980) is owner of “Kersten Corporate Finance” in The Netherlands, under which he works as an independent consultant in Mergers & Acquisitions (M&A’s) of medium sized companies.


Joris performs business valuations, prepares pitch books, searches and selects candidate buyers and/ or sellers, organises financing for takeovers and negotiates M&A transactions in a LOI and later in a share purchase agreement (in cooperation with (tax) lawyers).


Moreover, Joris is associated to ‘AMT Training London’ for which he provides training as a trainer and assistant-trainer in Corporate Finance/ Financial Modelling at leading investment banks in New York, London and Hong Kong.


And Joris is associated to the ‘Leoron Institute Dubai’ for which he provides finance training at leading investment banks and institutions in the Arab States of the Gulf.


In addition, Joris provides lecturing in Corporate Finance & Accounting at leading Universities like: Nyenrode University Breukelen, TIAS Business School Utrecht, the Maastricht School of Management (MSM), the Luxembourg School of Business and SP Jain School of Global Management in Sydney.


Moreover, he provides lecturing at partner Universities of MSM in: Peru, Surinam and Mongolia. And at partner Universities of SP Jain in Dubai, Mumbai and Singapore.


Joris graduated in MSc Strategic Management and BSc Business Studies, both from Tilburg University. In addition, he is (cum laude) graduated as “Registered Advisor Business Acquisitions” (RAB), a 1-year study in the legal and tax aspects of M&A’s. And Joris obtained a degree in “didactic skills” (Basic Qualification Education) in order to lecture at Universities.


Currently Joris is doing the “Executive Master of Business Valuation” to obtain his title as “Registered Valuator” (RV) given out by the “Netherlands Institute for Registered Valuators” (NIRV).


This title will enable Joris to give out business valuation judgements in for example court cases.



J.J.P. (Joris) Kersten, MSc BSc RAB. Email: Phone: +31 6 8364 0527


Earlier blogs on “Business valuation to Enterprise Value”


From June until August I have written the following blogs on valuation:


1. Leveraged Buyout Analysis (LBOs);


2. M&A Analysis” (M&A model – Accretion/ Dilution);


3. Discounted Cash Flow Valuation (DCF);


4. Valuation Multiples 1 – Comparable Companies Analysis (comps);


5. Excel Shortcuts & Business Valuation;


6. Valuation Multiples 2 – Precedent Transaction Analysis.


You can find them on the links below:


1) LBO Analysis (June 9th 2019):


2) M&A Analysis (June 20th 2019):


3) Discounted Cash Flow Valuation (July 24th 2019):


4) Valuation Multiples 1 – Comparable Companies Analysis (August 26th 2019):


5) Excel Shortcuts & Business Valuation (August 28th 2019):


6) Valuation Multiples 2 – Precedent Transaction Analysis (August 19th 2019):


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