WACC Estimation

Novartis (II)

Corporate Finance 1
 When do we need WACC?

• Asset appraisals
✓Capital budgeting: NPV
✓Financial accounting
• Company valuation
• M&A proposals
• Stock repurchases
• Performance assessment
• Optimal capital structure

Source: Practitioner’s guide to cost of capital & WACC calculation: EY Switzerland valuation best practice

Corporate Finance 2
 To Do...

1. Calculate Novartis’ current corporate WACC

2. Assume Novartis increases its leverage to 30%. How does this

capital structure adjustment affect Novartis’ WACC?

3. What will be the WACC for the Innovative Medicines and Sandoz
divisions after the spin-off?

Corporate Finance 3
 What is WACC?
(After-tax) cost of debt Cost of equity
𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸
Weights

Weighted Average Cost of Capital:

• It is a weighted average of the after-tax cost of debt and the cost of equity
• It represents the cost of capital for the firm
• It reflects the average degree of risk of the projects of the firm

Corporate Finance 4
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸
Q: Book values or market values?
• Market values: book values good approximation only if recorded when
✓ Interest rates were similar to today
✓ The firm’s credit rating was similar
Q: What to include in D?
• D in WACC stands for Net Debt = Debt – Cash Surplus
• Hybrid securities (convertible debt…) are considered debt if:
✓they are senior to equity, and
✓non-payment leads to bankruptcy
Corporate Finance 5
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸
Q: How to compute E?

• Public firm: use market value of equity:

𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝 = 𝑃𝑟𝑖𝑐𝑒 × 𝑁 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠

• Private firm:
✓Assume target leverage
✓Estimate with DCF or Multiples
Corporate Finance 6
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸

𝐷 = $13,874 Net debt (Ex. 5)

𝐸 = $211,662 Market capitalization (Ex. 5)

𝐷 𝐸
= 6.15% → = (1 − 6.15%)
𝐷+𝐸 𝐷+𝐸

Corporate Finance 7
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸

Q: How to compute corporate tax rate 𝝉?

Statutory or actual tax rate?
• Use actual tax rate
• Common practice: compute average (Tax/Taxable Income) ratio
• Include all taxes (e.g. country-level, local, etc.)

Corporate Finance 8
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸
Q: How to compute cost of debt 𝑹𝑫 ?

𝑹𝑫 = 𝑅𝐹 + 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑝𝑟𝑒𝑎𝑑
where 𝑅𝐹 = Risk-Free Rate

• Credit spread:
✓Represents creditors’ expected compensation over risk-free investment
✓Reflects creditors’ risk of investment
Corporate Finance 9
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸
Q: How to g𝐞𝐭 𝑹𝑫 ?
1. Own traded bonds (yield-to-maturity YTM) to directly determine 𝑅𝐷
2. Credit ratings → 𝑅𝐷 = 𝑅𝐹 + 𝑆𝑝𝑟𝑒𝑎𝑑
✓Use average credit spread of companies with same credit rating
3. Synthetic ratings → 𝑅𝐷 = 𝑅𝐹 + 𝑆𝑝𝑟𝑒𝑎𝑑
✓Use financial ratios to infer rating and credit spread
4. Cost of new bank loans
5. Interest Expenses / Debt (avoid if possible since backward looking)
Corporate Finance 10
 Interest Coverage Ratio and Credit Ratings
ICR > ≤ to Rating is Spread is
𝑅𝐷 = 𝑅𝐹 + 𝑆𝑝𝑟𝑒𝑎𝑑 8.5 100000 AAA 0.69%
6.5 8.499 AA 0.85%
5.5 6.499 A+ 1.23% Investment
𝐹𝐼𝑁𝐸𝑋 = 𝑅𝐷 × 𝐷 4.25 5.499 A 1.42% grade bonds
3 4.249 A- 1.62%
2.5 2.999 BBB 2.00%
2.25 2.499 BB+ 2.42%
𝐸𝐵𝐼𝑇 2 2.249 BB 3.13%
𝐼𝐶𝑅 =
𝐹𝐼𝑁𝐸𝑋 1.75 1.999 B+ 4.55%
1.5 1.749 B 5.26%
1.25 1.499 B- 7.37% Junk bonds
CCC 11.57%
↑ 𝑫 ⟹↑ 𝑭𝑰𝑵𝑬𝑿 ⟹↓ 𝑰𝑪𝑹 0.8 1.249
0.65 0.799 CC 15.78%
⟹↑ 𝑺𝒑𝒓𝒆𝒂𝒅 ⟹↑ 𝑹𝑫 0.2 0.649 C 17.50%
-100000 0.199 D 20.00%
Date: January 2023, source: http://pages.stern.nyu.edu/~adamodar/
Non-financial US companies
Corporate Finance 11
 Synthetic Ratings
Median financial ratio by credit rating

Source: Moodys Financial Metrics, “How Moody’s assesses FinancialCorporate

Viability”, Finance
Anke Rindermann, May 2022 12
 Spreads on Corporate Bonds

Moody's Seasoned Aaa and Baa Corporate Bond Yield Relative to Yield on 10-Year Treasury Constant
Maturity, Percent, Daily, Not Seasonally Adjusted. Source: Federal Reserve Bank of St. Louis.
Corporate Finance 13
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸

𝑅𝐷 = 𝑅𝐹 + 𝑺𝒑𝒓𝒆𝒂𝒅

Table 2 Table 1
US Treasury Yields 2023 Maturity Rate Interest Coverage
Business Segments Credit Rating Spread to Treasury
Ratio
1-Year 5.25%
Novartis A1 10.84 0.92%
5-Year 4.62%
Innovative Medicines Aa2 10.96 0.70%
10-Year 4.59%
Sandoz Baa2 8.58 1.47%
30-Year 4.72%

Corporate Finance 14
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸

𝜏 = 17% (Taxes/Taxable Income in 2022)

𝑅𝐷 = 𝑅𝐹 + 𝑺𝒑𝒓𝒆𝒂𝒅

= 4.59% + 0.92% = 5.51%

Corporate Finance 15
 Novartis’ Current WACC

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸
Q: How to compute cost of equity 𝑅𝐸 ?

Capital Asset Pricing Model (CAPM)

𝑅𝐸𝐶𝑢𝑟𝑟𝑒𝑛𝑡 = 𝑅𝐹 + 𝛽𝐸 × 𝑅𝑀 − 𝑅𝐹

= 4.59% + 0.55 × 6% = 7.89%

Corporate Finance 16
 Novartis’ Current WACC

Let’s complete the puzzle!

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 1 − 𝜏 𝑅𝐷 + 𝑅𝐸
𝐷+𝐸 𝐷+𝐸

= 6.15% × 1 − 17% × 5.51% + 1 − 6.15% × 7.89%

𝑾𝑨𝑪𝑪 = 𝟕. 𝟔𝟗%

Corporate Finance 17
Cost of
𝑅𝐸
capital

7.89%

7.69% 𝑊𝐴𝐶𝐶

𝑅𝐷 (1 − 𝜏)
5.51%(1-17%)

0% 6.15% 100%
𝐷
Current Leverage
𝐷+𝐸
Corporate Finance 18
 To Do...

1. Calculate Novartis’ current corporate WACC

2. Assume Novartis increases its leverage to 30%. How does this

capital structure adjustment affect Novartis’ WACC?

3. What will be the WACC for the Innovative Medicines and Sandoz
divisions after the spin-off?

Corporate Finance 19
 New WACC at 30% leverage?
𝐷 𝑁𝑒𝑤
✓ New WACC = 30%, assume 𝑅𝐷𝑁𝑒𝑤 = 5.51%:
𝐷+𝐸

𝐷 𝑁𝑒𝑤 𝐸 𝑁𝑒𝑤
𝑊𝐴𝐶𝐶 𝑁𝑒𝑤 = 1 − 𝜏 𝑅𝐷𝑁𝑒𝑤 + 𝑅𝐸𝑁𝑒𝑤
𝐷+𝐸 𝐷+𝐸

= 30% × 1 − 17% × 5.51% + 1 − 30% × ? ? ?

Q: How do we get 𝑹𝑵𝒆𝒘
𝑬 ?

Corporate Finance 20
Cost of 2) Relever 𝑅𝐸
capital
1) Unlever

𝑅𝐴 7.89%

7.69% 𝑊𝐴𝐶𝐶

𝑅𝐷 (1 − 𝜏)
5.51%(1-17%)

0% 6.15% 30% 100%

𝐷
Current New Leverage
(target) 𝐷+𝐸
Corporate Finance 21
 Steps to compute 𝑅𝐸𝑁𝑒𝑤 : Unlevering

1. Unlever 𝑅𝐸𝐶𝑢𝑟𝑟𝑒𝑛𝑡 to obtain 𝑅𝐴 :

𝐸 𝐶𝑢𝑟𝑟𝑒𝑛𝑡
𝐷(1 − 𝜏)
𝑅𝐴 = 𝑅𝐸 + 𝑅𝐷𝐶𝑢𝑟𝑟𝑒𝑛𝑡
𝐸 + 𝐷(1 − 𝜏) 𝐸 + 𝐷(1 − 𝜏)

211,662 13,874 × 0.83

= 7.89% + 5.51% = 7.77%
211,662 + 13,874 × 0.83 211,662 + 13,874 × 0.83

✓ The cost of assets 𝑅𝐴 is the cost of equity if the firm had no debt
✓ It reflects only the operational risk of the firm, not the financial risk
✓ It is also known as the unlevered cost of capital
Corporate Finance 22
Cost of
𝑅𝐸
capital
1) Unlever

𝑅𝐴 7.89%
7.77%
7.69% 𝑊𝐴𝐶𝐶

𝑅𝐷 (1 − 𝜏)
5.51%(1-17%)

0% 6.15% 30% 100%

𝐷
Current New Leverage
(target) 𝐷+𝐸
Corporate Finance 23
 Steps to compute 𝑅𝐸𝑁𝑒𝑤 : Relevering

𝐷 𝑁𝑒𝑤
2. Relever 𝑅𝐴 to new target leverage = 30%:
𝐷+𝐸

𝐷𝑁𝑒𝑤
𝑅𝐸𝑁𝑒𝑤 = 𝑅𝐴 + (1 − 𝜏) 𝑅𝐴 − 𝑅𝐷𝑁𝑒𝑤
𝐸

= 7.77%+? ? ? × 0.83 × (7.77% − 5.51%)

Corporate Finance 24
 Useful Trick!

𝐷 𝐷
✓ Trick to get if you have :
𝐸 𝐷+𝐸

𝐷 𝐷 𝑦
=𝑦→ =
𝐷+𝐸 𝐸 1−𝑦

✓ In our case:

𝐷 𝐷 0.3
= 30% → = = 0.43
𝐷+𝐸 𝐸 1 − 0.3

Corporate Finance 25
 Steps to compute 𝑅𝐸𝑁𝑒𝑤 : Relevering
𝐷 𝑁𝑒𝑤
2. Relever 𝑅𝐴 to new target leverage = 30%:
𝐷+𝐸

𝐷𝑁𝑒𝑤
𝑅𝐸𝑁𝑒𝑤 = 𝑅𝐴 + (1 − 𝜏) 𝑅𝐴 − 𝑅𝐷𝑁𝑒𝑤
𝐸

= 7.77% + 𝟎. 𝟒𝟑 × 0.83 × (7.77% − 5.51%)

= 8.57%

✓ Note: As an alternative to unlever/relever returns, you can unlever/relever betas

+ use CAPM formula: you will get same result!

Corporate Finance 26
Cost of 2) Relever 𝑅𝐸
capital
1) Unlever
8.57%

𝑅𝐴 7.89%
7.77%
7.69% 𝑊𝐴𝐶𝐶
???

𝑅𝐷 (1 − 𝜏)
5.51%(1-17%)

0% 6.15% 30% 100%

𝐷
Current New
𝐷+𝐸
Corporate Finance 27
 New WACC at 30% leverage
𝐷 𝑁𝑒𝑤
✓ New WACC = 30%:
𝐷+𝐸

𝐷 𝑁𝑒𝑤 𝐸 𝑁𝑒𝑤
𝑊𝐴𝐶𝐶 𝑁𝑒𝑤 = 1 − 𝜏 𝑅𝐷𝑁𝑒𝑤 + 𝑅𝐸𝑁𝑒𝑤
𝐷+𝐸 𝐷+𝐸

= 30% × 1 − 17% × 5.51% + 1 − 30% × 𝟖. 𝟓𝟕%

𝑊𝐴𝐶𝐶 𝑁𝑒𝑤 = 7.37%

Corporate Finance 28
Cost of 2) Relever 𝑅𝐸
capital
1) Unlever
8.57%

𝑅𝐴 7.89%
7.77%
7.69% 𝑊𝐴𝐶𝐶
7.37%

𝑅𝐷 (1 − 𝜏)
5.51%(1-17%)

0% 6.15% 30% 100%

𝐷
Current New
𝐷+𝐸
Corporate Finance 29
 Takeaways
• WACC is used for many different purposes across the company
• To compute WACC:
✓ Use market values
✓ Use CAPM model for cost of equity
✓ Use spreads for cost of debt
• If leverage changes, you need to:
1. Unlever
2. Relever
• Next session:
✓ Company risk vs. divisional risk
✓ Estimating divisional betas and expected rates of return

Corporate Finance 30