ERG (07) 05 PIBs on WACC - IRG

IRG-WG RA (<strong>07</strong>) WACC Master Doc
already used by many regulators. In calculating WACC NRAs should consider the
relative merits of pre-tax vs. post–tax.
3.2 The gearing ratio
The weighting used in the WACC formula is the company's gearing. The gearing is a
measure of the ratio of debt to company value (the latter being equivalent to the sum of debt
(D) and equity (E)) and is defined as:
D
Gearing =
D + E
There are a number of ways to determine the gearing level, each with a direct effect on the
cost of capital:
a) Based on book values: the gearing is calculated using the accounting value of the
company's debt and equity. This is a transparent method, easy to check and audit. The
downside with the use of book value is that it is not forward-looking and does not reflect
the company's true economic value. Besides, book values are dependent on the
operator's strategic and accounting policy and so they may vary substantially with
changes in the accounting principles, provided general accounting rules are respected;
b) Based on market values: the gearing can be calculated on the basis of the observed
market value of the company's debt and equity, namely its market capitalisation, which in
theory will reflect the true economic value of the company's capital structure. The market
value of equity can be obtained by multiplying the number of shares with their current
price. The market value of debt can be difficult to obtain directly since besides bonds
firms generally have other forms of non-traded debt, such as bank debt. However, book
values can be converted into market values by treating the entire book debt as one
coupon bond. 2 This coupon bond would be valued at the current cost of debt for the
company. However, the problem with the use of market values is that they are dependent
on several market factors, namely volatility, investors' expectations and speculation and
so they can be subject to serious fluctuations, negatively affecting market stability.
c) Optimal or efficient gearing: is based on an optimal capital structure defined by the
regulator. The reason for using this method is to ensure that firms that over-borrow or
borrow at too high a rate are not rewarded for this financial decision. This efficiency
adjustment can be done by taking into account the capital structure of an efficient
operator rather than the structure of actual operators. 3 However, establishing an optimal
ratio is a subjective issue.
2
The coupon should be set equal to the interest expenses on all the debt and the maturity set equal to
the weighted average maturity of all debt.
3
The definition of an optimal capital structure has to take into account several factors such as market
risk, tax advantages, credit ratings, investment levels, and so on.
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