Going "Distress" on the WACC Theoretical and empirical analysis

Resumen

WACC has traditionally been used as a measure of the cost of capital for companies and as a discount rate of the future company's cash flows for valuation purposes. The WACC, especially for "distressed" companies, can play a key role in determining the efficiency of the restructuring framework for companies heading into bankruptcy. The theory and the practice show that companies that file for Chapter 11 have a higher probability of rehabilitation as a going concern and boost the recovery of the stakeholders as a whole than more credit friendly restructuring frameworks. Additionally, rehabilitated companies from more debtor friendly proceedings that have undergone a profound restructuring through efficient tools should also enjoy a higher probability of survival. In the first part of the thesis, we aim to prove that empirically by thoroughly looking at the market based WACC of a sample of American and European companies one year before and after the filing date. If we meet with success, then we should be confident that the WACC could result in a powerful tool to evaluate the efficiency of the restructuring framework of the company's filing. In the second part, we look at the impact of Basel III on the banks and their capital structure. We discuss that the implementation of Basel III will turn the focus of banks towards the WACC rather than ROE due to overall increase in the cost of capital. Banks have traditionally enjoyed "cheap" funding due to the systematic support from the governments. Basel III advocates for a capital structure "bail-in" rather that "bail-out" coupled with higher capital requirements will make the achievement of high ROEs a difficult task. We compare the WACC under Basel II and Basel III frameworks and we draw some conclusions. We then focus on the CoCo, a debt like contingent capital instruments that converts into equity upon a credit event. The existence of the CoCo will boost the overall WACC due to its higher price as a result of its loss absorbing features. We conduct a theoretical and empirical model to evaluate the impact of the CoCos on the WACC on a pre and post conversion basis and the implications for the equity holders who have traditionally enjoy higher ROEs with low COEs and hence constant equity multiple expansion. Here, again, we expect to prove the useful role of the WACC in "distress" to suggest the optimal capital structure for banks. In summary, we attempt to genuinely contribute to the vast literature of the cost of capital, theoretically and empirically, by ¿coining¿ the expression ¿Going Distress on WACC¿. KEY WORDS WACC, solvency, restructuring, bail-in/out, Basel III, CoCo, capital structure.