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ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

Debt the debts promised interest and principal would

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debt, the debt’s promised interest and principal would be discounted using a discount rate of 8 percent. The valuation of non-traded complex financing (financing other than common stock and non-convertible debt) depends on the type of financing. For example, preferred stock is rated very much the way debt is rated. So, imagine a non-callable, non-convertible preferred stock issue paying a fixed dividend and justifying a BB rating, and assume that a BB rating implies a prevailing market dividend yield (dividend/price) of 6 percent. The estimated value of the preferred 3
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Estimating the WACC, page 4 of 25 would be the present value of the forecasted future dividend discounted at a 6 percent rate (price = [annual dividend/.06]). Financing with option properties (convertibles, warrants, firm issued puts, etc.) must be valued using an option-pricing model. Option valuation will not be covered here. I.2. Determining the Costs of Capital E r , D r and CFin r Estimating Equity Rate E r : Equity discount rate (cost of capital) E r is typically estimated using the CAPM. The CAPM equation for the equity cost of capital for firm X is: X E r = RF r + X equity β [ M r - RF r ] (2) Rate M r is the market rate of return over the coming time period (e.g., a year), which is unknown now and has a probability distribution. The market is the totality of risky assets in the economy; proxies for this are stock market averages, such as the Standard and Poor’s 500 or the Russell 5000. Quantity M r in (2) is the mean of the probability distribution of M r ; M r is the “expected rate of return on the market.” Rate RF r is the risk-free rate (usually estimated using the rate on a U.S. Government security). Parameter X equity β is the risk parameter (the beta ) for stock X; it indicates the stock’s risk from an investor portfolio standpoint. Beta X equity β reflects the degree to which firm X’s stock moves with the overall stock market. Quantity [ M r - RF r ] in (2) is referred to as the “equity premium.” The equity premium is the amount by which the expected return on the entire market of risky securities exceeds the rate on a “riskless” asset (such as a U.S. Government security). A publicly traded firm’s stock beta ( X equity β ), and the rates on U.S. Government securities, can be obtained from Bloomberg, Value Line, Standard & 4
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Estimating the WACC, page 5 of 25 Poor’s, and other sources. The equity premium ([ M r - RF r ]) can be obtained from Ibbotson Associates (and other data services). So, for a given publicly traded stock, equation (2) is readily computed. Stock betas are estimated using historical (past) stock price data. As a word of caution, the beta estimate for a particular firm’s stock (e.g., Intel common stock) will differ among information services that provide betas. This is because the services use different stock portfolios to represent the market (the S&P 500, the Wilshire 5000, the Value Line stock universe, etc.) and use different historical time periods to estimate betas. Estimating Debt Rate
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