ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

Lets fill in some of these details finding and

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Let’s fill in some of these details. Finding and Analyzing Comparables: For purposes here, a comparable is a publicly traded company that is very similar to Olive in terms of underlying business risk. Business risk is measured by the firm’s free cash flow (FCF) probability distribution. To identify comparables, a good place to start is Olive’s industry, since firms in a given industry are subject to similar supply and demand forces. We would also consider other industries with risk characteristics like Olive’s industry. For example, the sales of consumer products that are income sensitive and also appeal to consumers in the same income category may be highly correlated. The FCFs of some producers’ goods manufacturers are highly correlated because they depend on the general economy in similar ways. Keep in mind that we want to estimate the discount rate (WACC) to discount Olive’s future FCF. This means that we want each comparable to have a future like that of Olive (not simply a similar past history). Current market values and discount rates for a comparable reflect investors’ perceptions about the comparable’s anticipated future performance. Estimating a Comparable’s Capital Structure Parameters: Since the comparables are publicly traded, obtaining their 0 E , 0 D , and 0 CFin will likely not be difficult. Debt and complex financing that is not publicly traded can be valued on the basis of the firm’s business risk, capital structure, rating of the security 10
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Estimating the WACC, page 11 of 25 (e.g., bond rating), and provisions in the financing agreement. On this, see Section I.1 above. Estimating a Comparable’s E r , D r and CFin r : We can apply the procedures that were presented in Section I.1 here, including the use of the CAPM to estimate each comparable’s equity cost of capital E r . So, the equity cost of capital rates A E r , B E r , and C E r for firms A, B and C, respectively, would be computed in the following way. As in expression (3), assume that risk-free rate RF r = 4% and equity premium [ M r - RF r ] = 8%. Assume that we also have obtained from an external source (Bloomberg, Ibbotson Associates, etc.) the beta estimates A equity β = 1.0, B equity β = 1.25, and C equity β = 1.5; these quantities are shown in Exhibit 2 above. Using the CAPM, it follows that the equity rates for comparables A, B and C are calculated as shown in equations (7a), (7b) and (7c). A E r = RF r + A equity β [ M r - RF r ]= 4% + 1.00 [8%] = 12% (7a) B E r = RF r + B equity β [ M r - RF r ] = 4% + 1.25 [8%] = 14% (7b) C E r = RF r + C equity β [ M r - RF r ] = 4% + 1.50 [8%] = 16% (7c) STEP 2: D ETERMINE O LIVE S T ARGET C APITAL S TRUCTURE , D r AND E r . We assume that Olive plans to have only debt and equity in its capital structure. Therefore, Olive 0 CFin = 0. Set Olive 0 CFin = 0 in (5) and rearrange the terms and it follows that: Olive E r = Olive r + ( Olive r - Olive D r )[ Olive 0 D / Olive 0 E ] (8) Suppose that the target [ Olive 0 E / Olive 0 V ] = .8 and [ Olive 0 D / Olive 0 V ] = .2, which implies [ Olive 0 D / Olive 0 E ] = .25 (observe that the denominator in the ratio in (8) is Olive 0 E and not 11
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Estimating the WACC, page 12 of 25 Olive 0 V ). Note that we could not use (8)
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