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ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

# Step 1 estimate zeds opportunity cost of capital to

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Step 1 : Estimate Zed’s opportunity cost of capital. To do this, identify publicly traded companies that have an underlying business risk like that of Zed. We refer to these similar business risk companies as “comparables.” From data about Zed’s comparables, we infer Zed’s opportunity cost of capital ( Zed r ), which is the cost of capital appropriate to the underlying business risk of Zed and its comparables. Step 2 : Determine Zed’s target market value financing proportions ([ Zed 0 E / Zed 0 V ] and [ Zed 0 D / Zed 0 V ]) and debt cost of capital and, using that information and the estimated r from Step 1, determine Zed’s equity cost of capital. Step 3 : Use the data from Steps 1 and 2 to compute Zed’s after-tax weighted-average cost of capital, after tax WACC r - . The above three steps are very similar to Steps 1, 2, and 3 in Section I. We will now apply the above three steps to estimate the WACC for Project Zed. 14

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Estimating the WACC, page 15 of 25 STEP 1: E STIMATE Z ED S O PPORTUNITY C OST OF C APITAL Zed r . Project Zed’s opportunity cost of capital, r, is defined as: Zed r = Zed Zed Zed Zed 0 0 E D Zed Zed 0 0 E D r r V V + + Zed 0 Zed 0 CFin V Zed CFin r (11) Notice that (11) has the same form as (5). As for a privately held company in Section II, in analyzing a single project we look for publicly traded assets (firms) that have the same underlying business risk as does Zed. We then estimate the r for each of these “comparables” and compute their average r and use this average as our estimate of Zed’s r. So, let Project Zed be the production of a consumer electronics product, and that we identify three publicly traded manufacturers (Miko Corporation, United Industries, and Cora, Inc.) of similarly risky consumer electronic products. Miko, United, and Cora have the following characteristics. Exhibit 3. Data on Zed’s Comparables [ 0 E / 0 V ] [ 0 D / 0 V ] [ 0 0 CFin / V ] equity β E r D r CFin r r Miko .4 .5 0.1 1.375 15% 10% 12% 12.2% United 0.6 0.4 0 1.125 13% 9% N/a 11.4% Cora 0.8 0.2 0 1.000 12% 8% N/a 11.2% Average* 11.6% * 11.6% = (12.2% + 11.4% + 11.2%)/3. Using the Miko, United and Cora comparable data, we estimate the opportunity cost of capital for Zed to be Zed r = 11.6%. Again let RF r = 4% and [ M r - RF r ] = 8%. Beta measures Miko equity β = 1.375, United equity β = 1.125, and Cora equity β = 1.0 would be obtained from an external source (e.g., Bloomberg) and then used by the analyst (appraiser) to compute the equity rates for the comparables. The computation of the comparables’ equity rates is shown in (12a), (12b) and (12c) below. 15
Estimating the WACC, page 16 of 25 Miko E r = RF r + Miko equity β [ M r - RF r ] = 4% + 1.375 [8%] = 15% (12a) United E r = RF r + United equity β [ M r - RF r ] = 4% + 1.125 [8%] = 13% (12b) Cora E r = RF r + Cora equity β [ M r - RF r ] = 4% + 1.0 [8%] = 12% (12c) STEP 2: D ETERMINE Z ED S F

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Step 1 Estimate Zeds opportunity cost of capital To do this...

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