Page 83 - Bankruptcy and Reorganization Services

It should be noted that the appropriate rate to use to discount the expected tax savings from an NOL is
generally the equity cost of capital. The rate used to discount the tax savings from an NOL should reflect
the riskiness of the cash flows derived from the NOL. The tax savings from an NOL can only be realized
if a company has taxable income. Taxable income is determined after deducting net interest expense.
From a risk perspective, it is important to note that cash flows after deducting interest expense are equity
cash flows, by definition. In other words, the cash flows derived from an NOL are equity cash flows and
have the same risk. Accordingly, an equity discount rate is the rate that reflects the riskiness of cash
flows from the tax benefit of an NOL. The WACC on the other hand reflects the riskiness of cash flows
to the invested capital of a company, which are the combined cash flows to equity and debt holders. A
company can have positive invested capital cash flows even if it is unable to utilize an NOL. For exam-
ple, a company that has positive EBIT may not have taxable income after deducting interest expense.
Accordingly, a WACC will generally understate the riskiness of a company’s ability to utilize an NOL.

A single WACC is typically used in a discounted cash flow analysis. This assumes that the company’s
capital structure remains constant throughout the forecast period. However, for companies in financial
distress, the capital structure may change over time due to the company’s efforts to rightsize its debt
load. As a result, it may be necessary to estimate a different WACC each year. Estimating a variable
WACC involves forecasting debt and equity weightings along with the future cost of financing for each
component of the WACC over the forecast horizon and terminal period.

The debt and equity weighting used in the calculation of the weighted average cost of capital should be
based on market value, not book value. It is common to assume that book value of debt approximates
market value of debt. This can be true for financially healthy companies with recently issued debt. How-
ever, if a company is in financial distress, the market value of debt may be very different — it’s usually
lower — than the book value. For this reason, the WACC may be understated when the book value of
debt is used as a proxy for the market value in the WACC calculation if the subject company is in finan-
cial distress.

If a company’s capital structure changes as a result of a financial restructuring, the cost of both debt and
equity can be expected to change. As a company’s capital structure becomes less leveraged, the cost of
equity will theoretically decline as the equity becomes less risky. The cost of debt should also decline as
leverage is reduced due to a lower risk of default. The WACC, however, may remain more stable than
either of the debt or equity components because the capital structure weighting may offset the change in
the capital costs. Nevertheless, the analyst should evaluate the effect on the cost of debt and equity of
anticipated changes in capital structure in order to estimate an appropriate WACC.

© 2020 Association of International Certified Professional Accountants 81