FINANCE
ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

# I the wacc of a correctly valued publicly traded firm

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I. THE WACC OF A CORRECTLY VALUED PUBLICLY TRADED FIRM Suppose that management wants to compute the after-tax WACC for the company in order to evaluate new investments that will have similar business risk and financing as the company as it currently exists. Management believes that the prevailing market values of the company’s traded securities (equity, debt, etc.) are close to their intrinsic values. The after-tax WAAC, after tax WACC r - , is defined as: after tax WACC r - = 0 0 E D 0 0 E D r r V V + (1 - T) + 0 0 CFin V CFin r (1) 0 E , 0 D , 0 CFin are the current market values of the firm’s equity, debt and complex financing, respectively; and E r , D r , CFin r and T are the equity cost of capital (equity discount rate), the debt cost of capital (debt discount rate), the complex financing cost of capital (complex financing discount rate), and the firm’s tax rate, respectively. The firm’s tax rate T can often be determined from the company’s annual report or 10-K. If not, the tax rate could likely be obtained from an investment bank that follows the company, or from the company itself. In Sections I.1 and I.2 we discuss the estimation of the other terms in equation (1). I.1. Determining the E 0 , D 0 and CFin 0 : Market value data for the firm’s publicly traded securities are readily available by simply obtaining the market 2

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Estimating the WACC, page 3 of 25 quotes and multiplying by the quantity of the security that is outstanding. If all the company’s securities are publicly traded, 0 E , 0 D , 0 CFin are therefore easily computed quantities. Valuing securities that are not publicly traded is more difficult. For securities that do not have option characteristics (convertible securities, for example, have embedded options), the valuation is a fairly straightforward exercise. For example, valuing a particular issue of non-traded non-convertible debt can be performed as follows. [a] Analyze the debt’s risk level by studying the underlying business risk and financial structure (debt to assets level) of the company, and the specific provisions in the debt agreement (priority, nature of collateral, etc.). Financial ratios are often used in such an analysis. [b] Given the findings in [a], rate the debt (e.g., comparable to Standard and Poor’s A or BBB) and determine the yield to maturity on debt with that rating and a similar term to maturity and pattern of interest and principal payments, where yields to maturity can be obtained from Bloomberg and various other sources. [c] Value the debt by discounting the debt’s promised future interest and principal payments using the yield to maturity estimated in [b]. To illustrate, suppose that the firm has a debt issue X that would justify a Standard & Poor’s rating of A, that matures in 5 years, and that pays interest semi-annually and all principal in 5 years. Assume that such debt would have a current yield to maturity of 8 percent. To value the X- debt, the debt’s promised interest and principal would be discounted using a discount rate of 8 percent.
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