ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

# For the comparables because we did not have their r

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for the comparables because we did not have their r levels. Now to estimate Olive D r . To estimate Olive D r you can consult with a financing expert, or you can do the research yourself. The appropriate expert is an investment banker or commercial bank loan officer. You would provide information about Olive’s underlying business risk profile and about Olive’s planned capital structure. The banker will be able to estimate, based on data about similar business risks and financing, what the firm would have to pay, in terms of interest rate, for borrowed funds. The banker could forecast the rating (e.g., bond rating) that would apply to the company’s debt and the implied interest rate. Of course, you could do your own research on all of this, but you probably will have other responsibilities where you have more of a comparative advantage. Let’s assume that the interest rate on your debt will be Olive D r = 10%. We have determined that [ Olive 0 D / Olive 0 E ] = .25 and Olive D r = 10%, and that Olive r = 12.2% (from our comparables analysis; see Exhibit 2). Substitute these numbers into (8) and we get: Olive E r = Olive r + ( Olive r - Olive D r )[ Olive 0 D / Olive 0 E ] = 12.2% + (12.2% - 10%)[.25] = 12.75% (9) So, Olive E r = 12.75% . In Step 3, we use the above data to compute Olive’s WACC. STEP 3: C OMPUTE O LIVE S WACC . The quantity that we are trying to estimate for Olive is after tax,Olive WACC r - in equation (1). In Step 2 we concluded that: [ Olive 0 E / Olive 0 V ] = .8, [ Olive 0 D / Olive 0 V ] = .2, Olive D r = 10% and Olive E r = 12.75%. Suppose that T = 34%. Substituting into (1), we have: after tax,Olive WACC r - = Olive Olive Olive Olive 0 0 E D Olive Olive 0 0 E D r r V V + (1 - T) = (.8)(12.75%) + (.2)(10%)(.66) = 11.52% (10) 12

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Estimating the WACC, page 13 of 25 The after tax,Olive WACC r - = 11.52% would be used to discount Olive’s expected future free cash flow to value Olive’s equity. If Olive is a privately held firm, we would then apply a liquidity discount to the FCF discounted value to produce our estimate of Olive’s equity market value. III. ESTIMATING THE WACC FOR AN ASSET OR PROJECT OF THE FIRM As a matter of normal operations, both publicly traded and privately held companies value assets that are not publicly traded. Investment projects are valued (their NPVs are computed) when they are considered for adoption. A project’s WACC is the discount rate used to compute the project’s NPV. A project is of course not itself publicly traded; it is within the firm. Similarly, a parent may value a division or subsidiary that is not publicly traded, perhaps in preparation for a spinoff or other type of business reorganization. In all these cases, a discount rate, or cost of capital, is used in estimating the asset’s market value. An investment project of the company should be valued as though it were a “mini-firm” with its own cost of capital (that cost of capital depends on the risk of the project). But the cost of capital cannot be directly observed as for a publicly traded company. In that sense, estimating the cost of capital for a project is
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