What risk does WACC not cover?
Saw this question radonmly. I believe it does not cover operational risks of a company since the calculation of WACC only concerns a company's capital structure and market metrics such as cost of debt and cost of equity. You could argue that it captures operational risk by saying that if a company has trouble operating normally, the market would capture the operational issue and reflect it in the company's beta.
What do you think?
I’d say that’s true and could be part of the reasoning a WACC premium is sometimes added to companies that recently have come out of distress/re-organized.
bump
i think that the capm (and thereby wacc) doesnt give premiums for firm specific or diversifiable risks, so operational risks by a company will not be awarded a premium.
may be wrong, curious to hear thoughts
Assuming efficient markets (which they are not) a company’s market performance should technically incorporate operational performance into the consideration. Therefore, beta should capture operational risk. A risk not captured by WACC? Stupidity risk. Some dumbass in a company that makes a random stupid decision that impacts a company in a material adverse way.
Illiquidity premium Small cap premium Value premium (in academic studies it’s low price to book)
Similar to Fama French ?
Couldn't you just adjust for this in your cost of equity calc that flows into WACC? Rf + B(MRP) + illiquidity/small cap/etc.
Doesn’t cost of debt encompass the firm’s operational risks?
The risk you made mistakes in your model
WACC doesn't capture tail events, because beta doesn't capture tail events.
Example: cost of equity for an airline right now is a lot higher than CAPM would suggest.
Indirect costs of financial distress aren't included. Think if you're going to buy a new car, and you are indifferent between a Honda and a Ford. If you think Ford is going to go bankrupt in 2 years, your warranty is going to be much less valuable and you would choose a Honda.
Tail risks and unforeseen circumstances (eg Weinstein risks)
Assuming you use the CAPM to calculate your cost of equity, your WACC would be capturing the “MKT” risk factor, or the covariance of the target’s excess return with the market’s excess return. This represents the firm-specific exposure to changes in market-wide systematic risk, like how the macroeconomy is doing. The CAPM frequently has an r squared of less than 0.3 for individual companies, so in fact most of the risk is not being captured, but we use it for simplicity. The CAPM is just another factor-based asset pricing model with only one factor: MKT. The Fama-French five-factor model “FF5” is calculated using a multiple linear regression, so you will have a beta for each factor, which represents exposure to that factor. These include the excess return on small stocks (“SMB”), excess return on value stocks (“HML”), and a few others I don’t care to mention. At an investment bank, you will usually use an MSCI Barra Beta, which basically uses a multi-factor model to calculate the equivalent one-factor beta. You can run a factor regression (FF5, AQR) on the website Portfolio Visualizer, and get a cost of equity easily that way, which will represent actual risk exposure more accurately than MKT alone.
apart from, market cap, illiquidity and growth/value, would add esg, momentum, brand and spread. All of these factors can be found in only one concept: popularity. Check Roger Ibbotson, this guy is a beast
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