ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

Conceptually very similar to estimating the cost of

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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

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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
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.

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