1. A Step-by-Step Guide to Estimating the WACC in Practice

1.1. Situation A: Traded Shares; Firm is at the Target Capital Structure

Let's start with the simplest situation: Coffee's shares are traded on the exchange. Moreover, Coffee does not plan to change its capital structure. If so, all we need are the firm's current costs of debt and equity. We can estimate these costs using the methods described in the previous chapter.

Since Coffee's shares are traded, we have data to estimate its beta, and hence its cost of equity (\( k_E \)). Suppose we collect the following information:

 

Equity beta, \( \beta_E \)

1.2

Risk-free rate of return, \( R_F \)

4%

Market risk premium, MRP

7%

 

If so:

\( k_E = R_F + MRP \times \beta_E \) = 0.04 + 0.07 × 1.2 = 12.4%.

 

We also need the cost of debt (\( k_D \)). Suppose we have the following information:

 

Risk-free rate of return, RF

4%

Coffee's debt rating

A

Premium for A-rated debt above the risk-free rate

2%

 

As a first approximation, we can write:

 

\( k_D = R_F + 0.02 \) = 0.04 + 0.02 = 6%.

 

Finally, we need information about Coffee's capital structure and its tax rate:

 

Proportion of debt in the capital structure, D/(D+E)

40%

Proportion of equity in the capital structure, E/(D+E)

60%

Tax rate, \( \tau_C \)

30%

 

Consequently, we can compute the firm's WACC:

 

 \( WACC = 0.06 \times (1-0.3) \times 0.4 + 0.124 \times 0.6 \) = 9.12%.