ESTIMATING THE WACC - 13 pt lecture note F454 SPRING 2013

We will use the approach presented by brealey myers

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is the pre-tax WACC discussed earlier. We will use the approach presented by Brealey, Myers and Allen ( Principles of Corporate Finance ). Brealey et al use the term “opportunity cost of capital” to refer to the pre-tax WACC in the present context, and we will do the same. They argue that the opportunity cost of capital is independent of the firm’s capital structure (i.e., Olive r is the same for any financing proportions [ Olive 0 E / Olive 0 V ], [ Olive 0 D / Olive 0 V ], and [ 0 CFin / Olive 0 V ]) and depends only on Olive’s business risk. The higher is Olive’s business risk, the higher is Olive r . 8
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Estimating the WACC, page 9 of 25 Since we are unsure of the intrinsic market values of Olive’s equity and debt, we cannot at this point compute the proportions in (5). So, what we do is to examine publicly traded firms that have the same underlying business risk as does Olive, and then use the data about these comparable firms to estimate Olive r . Suppose that we identify three other companies (A, B, and C) that we regard as Olive’s comparables in terms of underlying business risk (you would prefer more than three if you can find them). Firms A, B and C have the characteristics shown in Exhibit 2 below. The estimate of Olive r is the average of the comparables’ r magnitudes. This average is Olive r = 12.2% . To compute a comparable’s r (the last column in Exhibit 2), we use the approach described in Section I for publicly traded companies to determine each comparable’s [ 0 E / 0 V ], [ 0 D / 0 V ], [ 0 0 CFin / V ], E r , D r , and CFin r . (As shown below, to determine a comparable’s E r we use its equity β and the CAPM.) We then substitute those six quantities into equation (5) to solve for that comparable’s r. Thus, using the data in Exhibit 2, we have: A r = A A A A 0 0 E D A A 0 0 E D r r V V + + A 0 A 0 CFin V A CFin r = [.8] 12% + [.2] 8% + 0 = 11.2% (6a) B r = B B B B 0 0 E D B B 0 0 E D r r V V + + B 0 B 0 CFin V B CFin r = [.6] 14% + [.4] 10% + 0 = 12.4% (6b) C r = C C C C 0 0 E D C C 0 0 E D r r V V + + C 0 C 0 CFin V C CFin r = [.5] 16%+ [.4] 9% + [.1] 14% = 13% (6c) Exhibit 2. Data on Olive Corporation’s Comparables [ 0 E / 0 V ] [ 0 D / 0 V ] [ 0 CFin / 0 V ] equity β E r D r CFin r r Firm A .8 .2 0 1.00 12% 8% n/a 11.2% Firm B .6 .4 0 1.25 14% 10% n/a 12.4% Firm C .5 .4 .1 1.50 16% 9% 14% 13.0% Average* 12.2% * 12.2% = (11.2% + 12.4% + 13.0%)/3. 9
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Estimating the WACC, page 10 of 25 Notice from Exhibit 2 that Firms A, B and C do not have the same r, which they would if their business risk were identical. In practice, the best that we can usually do is to identify comparables with similar, but not identical, risk. That is what we are assuming here. Above we showed how to compute each comparable’s opportunity cost of capital using the market data, and the estimated betas, shown in Exhibit 2. We did not address the issue of how one finds comparables, and we brushed over the determination of each comparable’s [ 0 E / 0 V ],[ 0 D / 0 V ],[ 0 CFin / 0 V ], E r , D r , and CFin r .
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