W9.0_RF_Determining Proper Weighted Average Cost of Capital (WACC) and Minimum Attractive Rate of Return (MARR)

1. PROBLEM DEFINITION

A state-owned Oil, Gas, and Energy company plans to build a new infrastructure financed by foreign investor. In order to attract more investor, the company wants to evaluate the proper Weighted Average Cost of Capital (WACC) and Minimum Attractive Rate of Return (MARR) value which will be applied in the feasibility study to determine whether the investment plan is still feasible or not. The company’s current WACC & MARR that used to be applied in the investment study are 10.68% & 12.85%.

2. DEVELOPMENT OF THE FEASIBLE ALTERNATIVES

To calculate WACC & MARR, the Author will use the following equations:

A. Capital Asset Pricing Model (CAPM)

CAPM provides a formula that calculates the expected return on a security based on its level of risk. The formula for CAPM is the risk-free rate plus beta times the difference of the return on the market and the risk-free rate. The cost of equity is calculated by using CAPM (R_s) formula:

Equation 1:

B. Weighted Average Cost of Capital (WACC)

WACC is the product of the fraction of total capital from each source and the cost of capital from that source, summed over all sources. WACC formula:

Equation 2:

C. Minimum Attractive Rate of Return (MARR)

MARR is the lowest return that you would be willing to accept given the following condition:

– The risks associated with the project

– The other opportunities for investment

Equation 3:

3. DEVELOPMENT OF THE OUTCOMES FOR EACH ALTERNATIVES

Calculation for WACC based on the top biggest oil, gas, & energy contractors in Indonesia. Because the company is a non-listed company, so it is difficult and takes a lot of effort to estimate the stock beta (ß_s). Therefore, other methods are required to estimate beta of the private company using the data in Table 1 below:

Table 1. Average of Beta and Average of D/E Calculation

To determine stock beta (ß_s), the Author will follow the steps published by Elvin Mirzayev:

Equation 4:

With Tax Rate 22% (as per Indonesian Regulation), The Unlevered Beta value will be the following:

In the final step, we need to re-lever the equity using the target D/E ratio of the private company:

And the WACC value will be as follow:

By using Analytical Hierarchy Process (AHP) for scoring the risk, we can get risk scoring as shown in Table 2 below:

Note: We are not going to perform the AHP process, we are going to use AHP result from Lita Liana (2014) research or calculation since it covers the scope of oil and gas activities in Indonesia.

Table 2. Risk Scoring based on risk matrix rank

Indonesia country risk in 2021 = 1.88% by Figure 1 below:

Figure 1. Country Default Spreads and Risk Premiums

Criteria for MARR shall be based on calculation of equation 3:

The risk scoring is using 0.87% (North Central) since the planned infrastructure will be built there.

Based on risk categories for income-producing projects, normal MARR Standards categories as follows (Sullivan, 2020:608)

1. High Risk – MARR = 25%
2. Moderate Risk – MARR = 18%
3. Low Risk – MARR = 10%

MARR Value (14.46%) falls between Low to Moderate Risk (10%–18%). Based on data analysis and criteria above we will determine the MARR to be used is 14.46% and will propose to update the company’s current value.

4. SELECTION OF CRITERIA

Calculated WACC and MARR will be compared with company’s standard WACC and MARR.

5. ANALYSIS AND COMPARISON OF THE ALTERNATIVES

Table 3. Comparison of Calculated WACC & MARR with Company’s Current WACC & MARR

As can be seen in Table 3 above, there is 1.03% deviation for WACC and 1.61% deviation for MARR of calculated vs company’s. One factor causing the differences is the discrepancy in beta estimation and computation, including data utilized for industry average beta. If the data and beta estimation utilized for the calculation are the same, the WACC & MARR deviations may show that the company’s management is utilizing a different estimate value for market premium which is lower than the equity risk premium that Damodaran estimated. It demonstrates how a different assessment of an investment’s risk by the person or business that calculates the WACC & MARR may result in a different WACC & MARR result that should be used.

6. SELECTION OF THE PREFERRED ALTERNATIVES

The company will evaluate the methodology used to determine its anticipated WACC and MARR and make sure that the risk premium chosen was the safest one for its prospective investments.

7. PERFORMANCE MONITORING AND POST EVALUATION OF RESULT

Since various geographic areas have varying risks, WACC & MARR values ought to be used in accordance with the project’s location and nature. Inappropriate WACC & MARR values (either too low or too high) could lead to investors making poor decisions and misjudging project or investment risk, which could undermine the company’s strategy to draw in investors to finance the infrastructure project. MARR values should be updated often in accordance with company strategy and business risk assessments.

References:

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