What’s going on with WACC rates in Australia?

What’s going on with WACC rates in Australia?

The technical committee discussed the topic of Weighted Average Cost of Capital (WACC) given that we are in the middle of year end reporting, and WACC is a critical input into performing asset impairment tests.  The general discussion acknowledged that there seems to be at times a disconnect between WACC rates used for investment and business valuation purposes versus WACC rates used by accountants and auditors for asset impairment testing (I may be stating the obvious here, but it is an issue that just won’t go away).

Further to this, there was long discussion around the impact of low interest rates, and what impact this was having on the calculation of WACC rates.  The RBA actually identified this issue within the last 12 months http://www.businessinsider.com.au/the-rba-just-acknowledged-interest-rates-wont-help-business-investment-in-australia-2015-6, as they noticed that the dramatic reduction in interest rates, has not necessarily flowed through into investment hurdle rates, therefore is not having the desired effect of encouraging more business investment and M&A activity.

The key components of WACC are cost of debt and cost of equity.  A key input is the risk free interest rate.  Ever since the onset of the GFC and historic low interest rates, there has been debate over what approach to use when determining the risk free rate.  Some suggest that some form of historical average is appropriate, as rates now are artificially low and will at some point revert to normal (whatever normal is).  Others take more of an objective view and simply use market observable risk free rates of government bonds, however simply adjust the equity market risk premium to offset this.  However we have had low interest rates for many years now, and have now seen rates turn negative.  In fact, it is difficult to foresee when rates will normalise.  So the question is whether WACC rates are indeed too high given where risk free rates are at.

There was also discussion around differences between WACC rates in the US vs Australia.  It seems that it is more generally accepted in the US to simply use the observable risk free rate (say 20 year US Govt bond yields), and that this has in fact been supported in a court of law.  In Australia however the view is that a long term historical average is more appropriate.  It is interesting to compare average WACC in the US vs Australia.  Whilst this is not necessarily that scientific, anecdotally, average WACC rates in Australia are around 9-10%.  Based on analysis performed by Damodaran, http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wacc.htm the average WACC rate in the US is around 6.3%, with 80% of WACC rates by industry below 8.4%.  As at 30 June 2016, 10 year US bond yields were around 1.6%.  Australian govt bond yields were around 1.9%.

This is a topic that will be discussed in more detail at our annual FTA conference.

Steven Cunico FFTP
Deloitte Australia