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

# Estimating debt rate d r rate d r is the interest

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Estimating Debt Rate D r : Rate D r is the interest rate that the company would have to pay on incremental borrowing (if there are multiple issues of debt, it is a value-weighted average of the incremental rate on each issue of debt). The rate on incremental debt of a particular debt issue can be measured by the yield to maturity on that debt. If the debt is publicly traded, that rate is observable. If the debt is not publicly traded, then an appropriate procedure would be the one described in Section I.1 above (by rating the debt based on the company’s business risk and financing, and the debt’s particular characteristics, and then determining the prevailing yield to maturity on similar debt). The debt cost of capital can also be estimated using the CAPM (by estimating the debt’s beta and then plugging into the CAPM formula). Estimating Complex Financing Rate CFin r : The procedure for estimating the cost of capital on complex financing depends on the nature of the complex financing. For non-callable, non-convertible preferred with a constant dividend, [dividend/market price] is the cost of capital. Complex financing with option characteristics (convertibles, etc.) should be evaluated using an option-pricing model. An investment or commercial bank can assist in estimating the incremental cost of a given type of complex financing. 5

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Estimating the WACC, page 6 of 25 I.3. Illustration Main Corporation’s management wants to estimate the company’s after-tax WACC. Main is publicly traded and management believes that the market prices of the firm’s securities approximate their intrinsic values. Main’s financing (using market values) is 0 E = \$300 million, 0 D = \$150 million, and 0 CFin = \$50 million. It is expected that the firm’s financial structure (financing proportions), capital costs, and tax rate (T) will not change significantly over time. Main’s marginal borrowing rate is 8% (so let D r = 8%), and the cost of capital for Main’s complex financing is 12% ( CFin r = 12%). The beta on the company’s stock, X equity β , equals 1.4. Suppose that the risk-free rate (based on U.S. Government treasury bills) is RF r = 4%; and the equity premium [ M r - RF r ] = 8%. Main’s corporate tax rate T is 35%. What is Main’s after-tax WACC, after tax WACC r - ? Solution: All of the needed data were provided above. We begin by computing the equity cost of capital E r using equation (2) . E r = RF r + X equity β [ M r - RF r ] = 4% + 1.4 [8%] = 15.2% (3) By definition, the value of the firm, 0 V , equals the sum of the value of all the firm’s securities. Therefore, 0 V = 0 E + 0 D + 0 CFin = \$300 million + \$150 million + \$50 million = \$500 million. Using the information in Exhibit 1 below, we have: after tax WACC r - = 0 0 E D 0 0 E D r r V V + (1 - T) + 0 0 CFin V CFin r = \$300 \$500 15.2% + \$150 \$500 8% (1 - .35) + \$50 \$500 12% 6
Estimating the WACC, page 7 of 25 = 11.88% (4) II. ESTIMATING THE WACC TO VALUE A FIRM Section I explained how to estimate the WACC for a firm that has publicly traded common stock that is assumed to be fairly valued in the market (i.e.,

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