ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013 -...

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Estimating the WACC, page 1 of 25 ESTIMATING THE WEIGHTED-AVERAGE COST OF CAPITAL by L. Schall This note explains how to estimate the discount rate (weighted average cost of capital, or WACC) for a firm or for a particular investment (e.g., a machine). Section I discusses the estimation of the WACC for a publicly traded company for which the analyst believes that the observable market value equals intrinsic value. In this case, the purpose of estimating the WACC is to determine the discount rate for computing the NPVs of newly proposed investments that have risk and financing similar to the existing company. Section II explains how to estimate the firm’s WACC if the purpose is to estimate the intrinsic value a publicly traded company that has a market value that may significantly differ from intrinsic value, or to value a privately held company for which there is no observable market price. In this case, comparables (firms with a business risk that is very similar to that of the firm being valued) are employed in the estimation procedure. Section III discusses the estimation of the WACC to be used as the discount rate to value a new project that has a risk that differs from that of the firm as a whole. Part of the WACC estimation process involves the estimation of beta, a measure of a stock’s (or any asset’s) risk. In most cases, the beta for a stock should be obtained from an outside source that specializes in risk analysis and beta estimation (such as Bloomberg, BARRA, or Ibbotson Associates). In fact, a cost of capital estimate can also be purchased (for example, from Ibbotson Associates). Why then should a financial manager be concerned with the WACC estimation process? There are at least three reasons. First, most companies compute their own discount rates, depending on an external information source largely to obtain market betas and interest rates. It is the job of the company’s finance staff to use these data to compute discount rates for valuation purposes. This note explains how that is done. Second, a company’s management should be the most informed about the drivers of the firm’s business risk. Even if an 1
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Estimating the WACC, page 2 of 25 outside consultant computes the company’s cost of capital, management will have to provide relevant information to enable that estimate. A financial manager who does not understand what a WACC is and how it is estimated will be at a loss in providing the key information required to generate a defensible WACC estimate. Third, knowledge of what constitutes “risk,” how it arises, and how it affects value (the WACC is a risk-adjusted discount rate for computing value), is essential in managing and controlling risk so that equity value is maximized.
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