Journal of Business and entrepreneurial
July - September Vol. 7 - 3 - 2023
http://journalbusinesses.com/index.php/revista
e-ISSN: 2576-0971
journalbusinessentrepreneurial@gmail.com
Receipt: 13 October 2022
Approval: 08 April 2023
Page 14-26
Determination of the Weighted Average Cost of
Capital (WACC) applied to a COOPAC of Lima
Cercado
Determinación del Costo Promedio Ponderado del Capital
(WACC) aplicado a una COOPAC de Lima Cercado
Leopoldo Zacarías Sánchez Rodríguez
*
ABSTRACT
In a context characterized by continuous changes, in
which political instability is coupled with the damage
caused by cyclone Yaku and the consequences of
heavy rainfall that affected large areas of the northern
coast of our country during the first three months of
2023. In addition, the actions taken by the
Superintendence of Banking, Insurance and AFP
against certain Savings and Credit Cooperatives, due
to the negative balances in their equity accounts,
have caused a high level of uncertainty and distrust
towards the management carried out by the Peruvian
cooperative system. This is due to the fragility of
their financial structures, both for those involved
internally and externally. Therefore, the main
objective of this study was to determine the
Weighted Average Cost of Capital in the financial
decision making of a savings and credit cooperative
in Lima Cercado. To achieve this, a descriptive study
was carried out that addressed the fundamental
concepts and appropriate techniques, based on a
theoretical review of the evolution of corporate
finance, considered a novelty in today's business.
Keywords: Capital structure, equity, financial debt,
cost of capital.
RESUMEN
En un contexto caracterizado por cambios
continuos, en el que la inestabilidad política se une a
* MsC Universidad César Vallejo, Lima, Perú. lzsanchezs@ucvvirtual.edu.pe
https://orcid.org/0000-0003-1192-2089
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los daños provocados por el ciclón Yaku y las
consecuencias de las fuertes precipitaciones que
afectaron amplias áreas de la costa norte de nuestro
país durante los primeros tres meses de 2023.
Además, las acciones emprendidas por la
Superintendencia de Banca, Seguros y AFP contra
determinadas Cooperativas de Ahorro y Crédito,
debido a los saldos negativos en sus cuentas
patrimoniales, han provocado un nivel elevado de
incertidumbre y desconfianza hacia la gestión llevada
a cabo por el sistema cooperativo peruano. Esto se
debe a la fragilidad que exhiben sus estructuras
financieras, tanto para los involucrados internamente
como para los externos. Es por ello que, el objetivo
principal de este estudio fue determinar el Costo
Promedio Ponderado del Capital en la toma de
decisiones financieras de una cooperativa de ahorro
y crédito en Lima Cercado. Para lograr esto, se llevó
a cabo un estudio descriptivo que abordó los
conceptos fundamentales y las técnicas apropiadas,
basándose en una revisión teórica de la evolución de
las finanzas corporativas, considerada como una
novedad en los negocios actuales
Palabras clave: Estructura del capital, capitales
propios, deuda financiera, costo del capital.
INTRODUCTION
Making an investment implies allocating a determined amount of economic resources,
generally money, with the objective of obtaining a financial benefit in a specific period
(Horno-Bueno, 2022). In this case, the benefit refers to the yield obtained by carrying
out such operation. To achieve this, it is necessary to have knowledge of fundamental
management tools that optimize decision making and generate the expected added value;
this implies using effective valuation criteria and handling relevant information, which
guarantees that the invested capital generates the expected profits, not only for those
directly involved, but also for the organizations that consider this activity as part of their
functions. Likewise, the global economy is characterized by a high degree of uncertainty,
which, together with the commercial dynamics between countries, makes financial tools
essential to mitigate the risks associated with decision making. One of these tools, in the
field of finance, is the cost of capital method. This method refers to the required rate of
return on an investment or the value of financial instruments in a given period, it is
crucial to determine the opportunity cost of capital invested by the company and
shareholders. (Haag and Koziol, 2023).
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Along the same lines, Afzal et al., (2023) considers that the cost of capital represents the
minimum return that a company must obtain from its investment projects to meet
investors' expectations and maintain the company's market value, and is considered an
important tool in investment and financing decisions.
This method predicts the behavior of competitive markets considering the relationship
between investment cost and risk. It impacts investment decisions, resource allocation,
information and risk management, reducing uncertainties and generating growth
opportunities through financing for companies; the combination of debt and equity
optimizes decisions by considering the opportunity cost (Mantecon et al., 2023).
(Mantecon et al., 2023).
Thus, Lilford, (2023), argues that the weighted average cost of capital (WACC) is a
widely recognized financial methodology used to determine a company's cost of financing
based on its capital structure and the composition of its sources of financing. The WACC
represents the weighted average of the individual costs associated with the different
types of financing that a company uses to support its operations; the main components
considered in the calculation of the WACC are the cost of debt and the cost of equity.
Basically, the weighted average cost of capital (WACC) is an essential tool for evaluating
a company's cost of financing. By considering both the cost of debt and the cost of equity,
the WACC provides a comprehensive perspective that takes into account a company's
capital structure. By accurately understanding and calculating the WACC, managers and
analysts can make informed investment decisions and evaluate the profitability of the
firm as a whole. (Dobrowolski et al., 2022)
For this research it will be of utmost importance to establish a brief theoretical
framework; in this context the theory is based on the article published in 1958 by
Modigliani and Miller, in which the application circumstances are exposed, revealing the
premises on which the companies are based to use a financing tool interchangeably. For
Modigliani and Miller the model proposes the idea of irrelevance in the financing
structure, showing that firms are not affected by the choice of financial instruments. In
this sense, the total cost of capital does not depend on the instrument selected; these
assumptions imply the absence of taxes, costs associated with bankruptcy and
information asymmetries (Kolari and Velez-Pareja, 2012). The contribution of these
authors implies that, by relaxing the established assumptions, the fundamentals of
corporate finance are fixed in three main areas; these areas are: information
asymmetries, agency problems and risk management. All these aspects support crucial
financial decision making in the management and planning process of companies.
In view of this, determining the cost of equity capital (Ke), as well as the weighted average
cost of capital (WACC) in a COOPAC of Lima Cercado, is a pleasant opportunity,
where theoretical knowledge and our professional experience over many years is used
to enrich this work.
Before starting to develop the methodology used to determine the weighted average
cost of capital (WACC), we must point out that the financing structure of COOPAC de
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Lima Cercado has a very special feature, which is reflected in its capital structure, which
will be described below.
MATERIALS AND METHODS
This research is framed within a quantitative study, since it seeks to measure and analyze
the WACC of COOPAC de Lima Cercado using numerical data and financial formulas.
The level is descriptive, since it seeks to describe and analyze the WACC of COOPAC
de Lima Cercado based on real data and financial factors; it does not seek to establish
causal relationships or causality, but rather to understand and present the current
situation of COOPAC's WACC. The study design used will be a case study as a specific
COOPAC located in Lima Cercado will be selected and relevant financial data will be
collected to determine the WACC. The approach will be analytical, as formulas and
methods will be applied to determine the weighted average cost of capital. The approach
will be deductive, as it will start from existing financial theory and apply concepts and
formulas to determine the WACC of the COOPAC under study. An analytical approach
will also be used, where available financial data will be analyzed and evaluation techniques
will be applied to obtain results and conclusions on the WACC. (Hernandez and
Mendoza, 2018).
Next, we will specify some basic concepts for the development of the cost of equity
capital and the cost of external financing and therefore the weighted average cost of
capital (WACC).
According to Huong (2023) WACC is the cost of resources employed by the firm in its
operations is perceived as an expense from the perspective of the firm, but is considered
a return from the perspective of the providers of funds, such as shareholders and
investors.
The cost of funding (CMPC), where capital is financed with external resources (bank
loans, bonds, customer savings, etc.), as well as equity financing, i.e., shareholder
contributions.
The average cost of capital is expressed by the following formula:
WACC = Kd(1-t) *(D/P+D) + Ke*(P/D+P) (1)
Where:
Kd=Cost of external financing
D=Financial debt
P=Equity
Ke=Cost of equity
T=Taxes
Cost of Equity Formula (Ke)
Ke = Rf + β*(Risk premium) + RP (2)
Where:
Rf=Risk-free rate
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β=Systemic risk
Rm=Market return
Risk premium= (Rm - Rf)
RP=Country risk
Risk Free Rate (Rf):
The zero risk rate, or risk-free rate, is a theoretical concept based on the premise that
in the economy there is an investment option that does not entail any risk for the
investor (Chávarri and Neciosup, 2022).
Systemic Risk (β):
Systematic or non-diversifiable risk is a concept from portfolio theory or modern
finance. It describes the residual risk that cannot be diversified, even if the individual
securities in the portfolio are optimally mixed.
Reyes-Clavijo, (2022) considers that systematic or non-diversifiable risk refers to the
risk generated when a number of financial institutions experience related failures in a
short period of time, resulting in a decrease in liquidity and an increase in distrust in the
financial system as a whole.
It should be noted that many companies generally use the systemic risk (β) by type of
industry sector that has been developed by Damodaran, which can be found at the
following link: www.damodaran.com
Market Return (MR):
The market rate of return on equity is equal to the combination of the rate of change
of the net present value, which is influenced by expectations, and the ratio of the
accounting rate of return to the valuation rate at the beginning of the period.
Risk Premium:
In economics, the risk premium is the difference in the interest rate that an investor is
paid when assuming a certain investment with a lower economic reliability than another.
For Ceballos and Mongrut (2021) the risk premium is the additional return that investors
require (in the form of interest) when buying a country's sovereign debt, compared to
what they demand from other countries.
Country risk (PR):
Country risk is any risk inherent in investments and financing in one country as opposed
to another.
According to Llada (2021), country risk relates to a country's ability and willingness to
meet its debt obligations; it implies the possibility that a government's actions may
directly or indirectly affect its ability to meet its commitments in a timely manner.
Another important point to take into consideration is that when determining the
systemic risk (β) of a particular company, in order to calculate its weighted average cost,
the following formula should be taken into consideration:
Where:
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D = Financial Debt
E = Equity
The cost of equity (Ke) is calculated using the financial asset pricing model known as
CAPM. This model determines the return required by an investor when investing in a
financial asset, as a function of the risk assumed. It was developed by Treynor, Sharpe,
Lintner and Mossin, based on Markowitz's previous work on diversification and Modern
Portfolio Theory. Sharpe received the Nobel Prize in Economics along with Markowitz
and Miller for his contribution to financial economics.
Other considerations to be taken into account are the following:
Systemic risk (β) = 1
Ke = Rm (4)
Systemic risk (β) > 1
Ke > Rm (5)
Systemic risk (β) < 1
Ke < Rm (6)
(7)
RESULTS
Before starting the calculation of the cost of equity (Ke), as well as the cost of financial
debt (Kd) and therefore the weighted average cost of capital (Wacc), we will now detail
the data that has been taken into consideration for the calculation as of December 31,
2022.
Systemic Risk (β): 0.11
The coefficient of 0.11 has been obtained through the web page: www.damodaran.com,
corresponding to the sector corresponding to the year 2022; since the calculation of
the cost of financial debt (Kd), cost of equity (Kd) and the weighted average cost of
capital (WACC), is being calculated as of December 31, 2022.
Market Yield: 10.54%.
The Standard & Poor's 500 index, also known as the S&P 500, is one of the most
important stock market indexes in the United States. The S&P 500 is considered the
most representative index of the real market situation.
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This 10.54% yield has been obtained through the yields of financial assets, as shown in
the data below. Data considered from December 2018 to December 2022.
In the Peruvian case, the performance of financial assets has been taken from the
information provided by the Peruvian stock exchange and/or Bloomberg Financieros.
Risk Free Rate (Rf)
Obtaining the risk-free rate of 2.93% (average year 2022), which is the yield rate of U.S.
treasury bonds for a 10-year term with a risk exposure of zero. The data obtained is
shown below.
Table 1: Yield data according to Bloomberg financials
Source: Own elaboration
Country Risk (PR)
As can be seen in the following figure, Peru's country risk exposure as of December 28,
2022 was 1.90%, which is well below that of other countries in the region.
Figure 1: Peru Country Risk
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The financial structure of COOPAC de Lima Cercado is somewhat different from other
cooperatives in the sector, since its main source of funding comes from member
contributions, as can be seen in the capital structure presented below.
The financial debt as of December 31, 2022 represented the amount of S/2,696,235.46,
while the invested capital, which is equal to the financial debt plus the net equity, totaled
S/113,258,994.66, meaning that the Cooperative is financed with 2% of financial debt and
98% with its own resources.
Table 2: Financial structure
Source: EEFF COOPAC of Lima Cercado
After having obtained the proportion of financial debt with respect to net worth as of
December 31, 2022, which represents 2%, in addition to having as data the systemic risk
by type of industrial sector USA, as well as the application of the dispersion of the yields
of the financial assets, both of the Peruvian market and of the North American market,
the β of the Peruvian financial sector was determined at first, in order to later determine
the β of our cooperative, which as of December 31, 2022 represents a coefficient of
0.1290, as explained in detail below.
The following formula was used:
(8)
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Table 3: Calculation of the B CACSO
Source: Own elaboration
Calculation of the Cost of Equity (Ke) COOPAC de Lima Cercado.
Taking into consideration the risk-free rate (Rf), the yield of the American market (Rm),
the country risk, as well as the β of our cooperative, the cost of equity of COOPAC SO
de Lima Cercado (Ke) has been determined, estimating an annual cost of 5.81%, which
in monthly terms represents 0.47%. It should be pointed out that, according to theory,
the cost of equity capital is higher than the cost of financial debt as a result of the greater
risk assumed by the investor, which is why we can corroborate in this study that this
theory is true; however, we should point out that "COOPAC de Lima Cercado" has a
certain peculiarity in terms of its financing, since it is financed in greater proportion
through the contributions of its members (equity capital 98%). Finally, we should
mention that the cost of capital is the minimum rate of return that the cooperative must
obtain on its investments so that their value remains unchanged.
The following formula was used:
(9)
Table 4: Calculation of shareholders' equity
Source: Own elaboration
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From the numbers calculated above we can see that the Systemic Risk (β): 0.11 is less
than 1, while the cost of equity (Ke) is less than the market return (Rm).
Calculation of the Weighted Average Cost of Capital (WACC) COOPAC de Lima
Cercado:
After having determined the cost of equity (Ke), in addition to knowing the ratio of
equity to invested capital, the cost of financial debt and the ratio of financial debt to
invested capital, the weighted average cost of capital (WACC) at book value was
calculated, determining an annual cost of 5.81%, which in monthly terms represents
0.47%.
The following formula was used:
(10)
Table 5: WACC results
Source: Own elaboration
Tax Aspect
General Law of Cooperatives (Supreme Decree No. 074-90TR)
Title I
General
Article 1.- The promotion and protection of Cooperativism, as an effective system to
contribute to economic development, to the strengthening of democracy and to the
achievement of social justice, is hereby declared of national necessity and public utility.
Article 2.- The State guarantees the free development of Cooperativism and the
autonomy of cooperative organizations.
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Every cooperative organization shall be constituted for non-profit purposes, and shall
seek, through its own efforts and the mutual aid of its members, their immediate service
and the immediate service of the community (1)(2).
(1) Pursuant to Article 1 of Law No. 29683, published on May 13, 2011, it is specified
that, in accordance with this article, cooperatives, by their nature, perform cooperative
acts, which are defined as those performed internally between cooperatives and their
members in compliance with their corporate purpose. Cooperative acts are acts proper
to their mandate with representation, these are not for profit.
(2) Pursuant to Article 2 of Law No. 29683, published on May 13, 2011, it is specified
that, in accordance with this article, cooperatives are not subject to the General Sales
Tax (IGV) for transactions carried out with their members.
In compliance with current regulations, the COOPAC in question is exempt from taxes
on operations related to its CORE BUSINESS.
Valorization of the Lima Cercado COOPAC
COOPAC de Lima Cercado is valued at book value, since it is a cooperative sector
company and due to the nature of its operations, its shares have no market value.
CONCLUSIONS
The results of the research entitled 'Determination of the Weighted Average Cost of
Capital (WACC) applied to a COOPAC of Lima Cercado' show that the weighted
average cost of capital (WACC) applied to a COOPAC of Lima Cercado is 5.81% per
year, which is equivalent to 0.47% per month. The calculation was made using the book
value and considering the cost of equity (Ke), the ratio of equity to invested capital, the
cost of financial debt and the ratio of financial debt to invested capital. It is important to
note that the WACC is a measure used to evaluate the minimum profitability that a
company must achieve to remunerate its investors, taking into account the cost of
financing and the capital structure of the company. (Lilford, 2023), In this case, COOPAC
de Lima Cercado has a WACC of 5.81%, which implies that the company must obtain a
profitability equal to or higher than this percentage to meet investors' expectations and
justify the use of financial resources. It should be mentioned that these results are
specific to COOPAC de Lima Cercado and may vary depending on the financial situation
and characteristics of other companies or institutions. It is important to perform a
detailed analysis of each particular case to determine the appropriate WACC.
In conclusion, according to the Modigliani and Miller theorem, the value of a company is
not affected by the way it is financed, either through its own resources or those of
others. In the case of Cooperativa de Lima Cercado, it has a certain peculiarity in its
capital structure. The capital structure of the COOPAC in question as of December 31,
2022 is made up as follows: Financial debt: 2% and equity: 92%; it is evident that the main
source of financing comes from the contributions of the members, which makes its
funding cheaper compared to presenting a different structure. The cost of equity (Ke)
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as of December 31, 2022, has been determined at 5.81%, which in monthly terms is
equivalent to 0.47%, likewise the weighted average cost of capital (WACC) at book value
as of December 31, 2022, has been determined at 5.81%, which in monthly terms is
equivalent to 0.47%, meaning that this is the minimum return required by the
Cooperative with respect to its CORE business investments. Finally, Modigliani and
Miller base their theory on three branches: Information Asymmetry, Agency Problems
and Risk Management; these points must be very well valued, since they support the
financial decision making of the organization, emphasizing also that, although it is possible
to arrive at a numerical value as a management indicator, it is its interpretation and use
of the information obtained that will make the difference between one institution and
another.
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