When calculating WACC for a company operating in the eurozone, most of the parameters are the same regardless of the specific country in which the company operates. However there might be substantial discrepancies due to different financial markets and corporate taxation: we will try to outline some of these aspects relating to companies based and operating in Italy.
Managing 4 main Risks
We will focus our short analysis on four main issues that may influence our calculation of WACC when working on a company whose seat and main activity is located in Italy. The first deals with the Equity Risk Premium (ERP) that we should apply taking into consideration that the Italian equity market has a lower liquidity compared to other equity markets in the eurozone. The second deals with the huge problem of these years: the Country Risk Premium. The third deals with the calculation of the cost of debt in an environment where the bank credit crunch is relevant. The fourth deals with the after tax cost of debt after with limited percentage of tax deduction of interest expenses.
Equity Risk Premium (ERP) and the issue of Lack of Liquidity
Equity Risk Premium (ERP) in WACC may be computed as historical ERP or forward-looking ERP and we can all rely upon well known equity market studies. We apply ERP as an global equity premium, regardless of the country in which the company operates, because its country risk is measured separately with the Country Risk Premium. However when dealing with the equity market in Italy we should consider two main aspects: one, the market is strongly correlated to international equity markets (see the correlation between FTSE Mib 30 and MS World index) which confirms that the ERP is a global concept; two, the Italian Equity market is less liquid then other markets or, more specifically, the number of shares actively negotiated on the Italian equity market is limited compared to the number of shares issued and the number of IPO is poor. The lack of liquidity for Equity instruments in Italy means a higher risk that we either add to the ERP (if we consider this as a global risk) or we add it to the company's Beta (should we consider it as a specific risk). In any case, do not forget it in your WAAC.
Country Risk Premium: CDS vs T Bonds rate n WACC calculation
Country Risk Premium is THE Risk of this age. We are reluctant in using Country Default Spread (CDS) as a proxy of risk in WACC calculations because CDS are computed for a different scope. We are more confident in applying local T Bills rate as a proxy of Risk Free, thus incorporating the CRP spread for Italian T bills. In addition, we generally choose the 7 year duration as our preferred maturity, because the volume of transactions on the market in Italy is high and prices are accurate.
Cost of Debt: spread on commercial loans
The calculation of the cost of debt in an environment where the bank credit crunch is relevant mat also bring some uncertainty in the WACC calculation. The bank spread actually paid by the company in Italy may not be the one we should use, as this might not be applied to further debt needs. We would therefore consider also the cost of additional refinancing, especially if the business needs additional funds. The difference between the two costs may be relevant.
The after tax cost of debt after with limited interest expenses tax deduction
Our last point deals with the Italian taxation of interest expenses. Interest expenses are tax deductible in Italy only for an amount calculated as a percentage of EBITDA. which means that the portion of interest expenses in excess to the limit is not tax deductible. The after tax cost of debt in Italy is therefore calculated with a formula which is quite complex and different from the usual formula that we use in countries where interest expenses are totally tax deductible.
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