ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

E market value is close to intrinsic value so there

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traded common stock that is assumed to be fairly valued in the market (i.e., market value is close to intrinsic value, so there is no need to estimate the stock’s intrinsic value). This section explains how to estimate the WACC if the intrinsic value of the common stock is not known. This is a common problem for privately- held companies (for which there is no quoted stock price), and also for publicly traded firms in cases in which the analyst (appraiser) believes that the equity market value may be significantly different from intrinsic value. Business acquisitions often involve this issue (generally, both buyer and seller will want an intrinsic value estimate) whether the acquired company is publicly-held or privately-held. Before proceeding, it is worth mentioning that the capital asset pricing model (CAPM), the Modigliani-Miller analysis, and virtually all finance equations are based on assumptions that only approximate actual conditions. The equations are therefore, at best, approximate. At present we have no model for estimating the cost of capital that is complex enough, and accurate enough, to be precisely correct. But the two most widely used approaches (the one described in this section and the alternative method of using levered and unlevered betas) are widely employed in practice because they provide good estimates. The approach described below parallels the Brealey, Myers and Allen, Principles of Corporate Finance , Chapter 19. Define Olive 0 E , Olive 0 D , 0 CFin as the current intrinsic values of Olive’s equity, debt and complex financing, respectively; and define Olive E r , Olive D r , and Olive CFin r as Olive’s equity cost of capital, debt cost of capital, and the complex financing cost of capital, respectively. Rate Olive r signifies Olive’s opportunity cost of capital (to 7
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Estimating the WACC, page 8 of 25 be defined later). T is Olive’s marginal corporate tax rate. The approach presented here entails the following three steps. Step 1 : Estimate Olive’s opportunity cost of capital. To do this, identify publicly traded companies having a business risk like that of Olive. We refer to these similar business risk companies as “comparables.” From data about Olive’s comparables, we infer Olive’s opportunity cost of capital ( Olive r ), which is the cost of capital appropriate to the business risk of Olive and its comparables. Step 2 : Determine Olive’s target capital structure and debt cost of capital ( Olive D r ) and, using that information and the estimated Olive r from Step 1, determine Olive’s equity cost of capital ( Olive E r ). Step 3 : Use the data from Steps 1 and 2 to compute Olive’s after tax WACC r - . We will now discuss each of the three above steps in detail, using Olive to illustrate the concepts. STEP 1: E STIMATE O LIVE S O PPORTUNITY C OST OF C APITAL r. Olive’s opportunity cost of capital , Olive r , is defined as: Olive r = Olive Olive Olive Olive 0 0 E D Olive Olive 0 0 E D r r V V + + Olive 0 Olive 0 CFin V CFin Olive r (5) The rate Olive r is the pre-tax WACC discussed earlier. We will use the approach
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