ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

When the firm issues new debt to finance project zed

Info icon This preview shows pages 19–23. Sign up to view the full content.

View Full Document Right Arrow Icon
When the firm issues new debt to finance Project Zed, it receives an amount from the lender that is equal to the present value of what the firm will pay to the lender in interest and principal in the future. Borrowing is, at least approximately, a zero net present value activity for the borrower and for the lender (in a competitive market, lenders earn just their cost of capital, implying that lending for the lender is a zero NPV activity). The NPV of Project Zed goes to the firm’s (Todd Corporation’s) shareholders. This means that the market value of the additional debt issued to finance Project Zed, Zed 0 D equals the amount received by the firm to finance the initial outlay; that is: Zed,Debt 0 I = Zed 0 D (20) 19
Image of page 19

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

View Full Document Right Arrow Icon
Estimating the WACC, page 20 of 25 Since [ Zed 0 D / Zed 0 V ] = .4 (see assumption immediately preceding equation (13)) and Zed 0 V = $150 million (see (18a-b)), it follows that: Zed 0 D = 0 0 Zed Zed D V Zed 0 V = .4 ($150 million) = $60 million (21) Equations (20) and (21) imply that: Zed,Debt 0 I = $60 million (22) Using (16): Zed,Equity 0 I = Zed 0 I - Zed,Debt 0 I = $100 million - $60 million = $40 million (23) Thus, given that Zed 0 V = $150 million and Zed 0 I = $100 million, in order to meet market value target [ Zed 0 D / Zed 0 V ] = .4, the funds to finance Project Zed’s initial cost ( Zed 0 I = $100 million) must be in the form of Zed,Debt 0 I = $60 million and Zed,Equity 0 I = $40 million . 20
Image of page 20
Estimating the WACC, page 21 of 25 ANOTHER ILLUSTRATION: Blarney Beer Corporation plans to introduce a new ale, Debenture Ale. This project (Project Debenture) will require an initial outlay of $40 million, and is judged by management to be significantly riskier than Blarney’s existing product line. STEP 1: E STIMATE P ROJECT D EBENTURE S O PPORTUNITY C OST OF C APITAL Deb r : Project Debenture will be financed with additional Blarney Corporation debt and equity; there will be no complex financing ( Deb 0 CFin = 0). The opportunity cost of capital for Debenture Ale is therefore defined as follows: Deb r = Deb Deb Deb Deb 0 0 E D Deb Deb 0 0 E D r r V V + + Deb 0 Deb 0 CFin V Deb 0 CFin = Deb Deb Deb Deb 0 0 E D Deb Deb 0 0 E D r r V V + (24) Blarney has identified four relatively small publicly traded breweries that have risks similar to Project Debenture. They have the following financial characteristics. Exhibit 4. Debenture Ale Comparables [ 0 E / 0 V ] [ 0 D / 0 V ] [ 0 0 CFin / V ] equity β E r D r CFin r r Spike .4 .5 .1 1.25 14% 8% 16% 11.2% Bluebeard .2 .8 0 1.50 16% 12% n/a 12.8% Firebird .7 .3 0 1.125 13% 10% n/a 12.1% Gazelle .5 .5 0 1.25 14% 11% n/a 12.5% Average* 12.15% * 12.15 = (11.2% + 12.8+ 12.1% + 12.5%)/4. The opportunity cost of capital is computed using equation (9). The estimated opportunity cost of capital for Project Debenture is Deb r = 12.15%. 21
Image of page 21

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

View Full Document Right Arrow Icon
Estimating the WACC, page 22 of 25 The comparables’ equity rates (the E r ) are computed using the equity β shown in Exhibit 4. Assuming that RF r = 4% and [ M r - RF r ] = 8%, it follows that (using, from Exhibit 4, Spike equity β = 1.25, Bluebeard equity β = 1.50, Firebird equity β = 1.125 and Gazelle equity β = 1.25): Spike E r = RF r + Spike equity β [ M r - RF r ] = 4% + 1.25 [8%] = 14% (25a) Bluebeard E r =
Image of page 22
Image of page 23
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