WACC becoming higher than rE due to negative net debt?
Dear WSO,
I am writing my thesis, a valuation of a biotech company who obviously has much more financial assets than obligations, meaning that net debt becomes negative. If one plugs this into the pre-tax WACC (as one should, since no tax shield exists on financial income), the WACC becomes higher than the required return on equity?
What I'm thinking so far is, that since net debt is negative, it makes sense that: equity holders no longer ONLY require a return on the operational assets (rE), but ALSO on the financial assets - which makes the WACC become higher than rE... The flaw in this argument, as I see it, is that your financial assets are invested in treasury bonds etc., which are almost risk-free, meaning that the overall risk of the company should be lower - since it has no debt obligations (technially, since they could always pay off the entire debt)? If this is true, then WACC should be LOWER than rE - since a lower risk means a lower WACC..
Can someone provide a thorough explanation? My supervisor for my thesis is of no help..
Am I missing something? Correct me if I'm wrong....
WACC uses the leverage ratio (D/(D+E)) to weight the cost of debt. If the firm has any debt, it has a positive ratio, and that debt has some required return (Rd) based on the debt terms. Not sure where the Net Debt comes into play as that is typically used for Total Enterprise Value --> equity value, and potentially if you're levering/unlevering Beta in CAPM. If you use Net, you have to use Net debt ratios throughout your analysis. If you use Gross, you use Gross ratios throughout your analysis. If Net is negative, I'd just use Gross for the sake of the analysis, unless you can define some astounding impact the difference in calculation would potentially have in understanding firm valuation (arbitrage or a new norm).
If the firm has high levels of cash, the cost of debt is low, but there technically is debt if it's on the balance sheet. The firm will have a great credit rating (assuming the business will continue functioning well going forward) and equity holders will require a lower rate of return since there is no leverage/gearing and their risk assumed is substantially lower. The levered beta equity holders are exposed to in the CAPM has a lot to do with the leverage as well. Equity holders are first loss positions and they are exposed to the volatility the debt creates in levering a firm.
Low levels of leverage can sometimes provoke activist investing since the firm has capital sitting on the sideline that it's not using to grow the business. Equity holders would require a higher return as that cash is used for growth.
I see your point in trying to understand a co-mingled return based on the return of debt as well, but I would classify them separately.
If net debt is negative, just consider it zero and then consider the excess cash/securities separately. In which case your WACC will equal your return on equity.
And how does one consider the cash/securities seperately?
Est aut qui consectetur maiores ut. Est enim tenetur corrupti molestiae minima quo labore quos. Et dolor voluptates repudiandae maxime. Deserunt qui minus laboriosam voluptas aut. Sit pariatur nulla unde laborum alias. Corrupti dolores esse ut rem fugiat. Dolores inventore non voluptatibus hic dolores labore dolores.
Rerum ullam laboriosam suscipit omnis. Corrupti pariatur cupiditate eveniet ullam error vel. Aspernatur ipsum voluptate quo soluta quia in quo.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...