ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

Conceptually very similar to estimating the cost of

Info icon This preview shows pages 13–16. Sign up to view the full content.

View Full Document Right Arrow Icon
conceptually very similar to estimating the cost of capital for a company that is not publicly traded (see Section II above). The financing weights used in Section II for a privately held company were the target financing proportions for the company (see Step 2 on page 9). For a single project of the company, the financing weights to use in computing the project’s WACC are the targeted incremental changes in the firm’s overall financing that will result from the project. To illustrate the point, suppose that Todd, Inc. is evaluating Project Zed. Zed will be financed with debt and equity capital. The value of the project equals the present value of the project’s expected future FCF computed using the appropriate WACC (just as the value of Olive in Section II was the present value of Olive’s expected future FCF using 13
Image of page 13

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Estimating the WACC, page 14 of 25 Olive’s WACC). The NPV of the project is the value of the project minus the project’s initial outlay. We will use an example to illustrate the estimation procedure described here. Assume that Todd Corporation is considering Project Zed and needs an appropriate WACC to discount Project Zed’s cash flows in order to compute its NPV. Define Zed r , Zed E r , Zed D r and Zed CFin r as Zed’s opportunity cost of capital, equity cost of capital, debt cost of capital, and complex financing cost of capital. [ Zed 0 E / Zed 0 V ], [ Zed 0 D / Zed 0 V ] and [ Zed 0 CFin / Zed 0 V ] are the market value financing proportions for project Zed (we will assume only equity and debt financing of Zed, so [ Zed 0 CFin / Zed 0 V ] = 0). The following three steps are involved in estimating Zed’s WACC. 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
Image of page 14
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.
Image of page 15

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 16
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern