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

1.3. Situation C: Shares not Traded on an Exchange

The third possibility is that Coffee's shares are not traded on the exchange. This implies that we do not have sufficient information to estimate the cost of equity using market data. 

 

In such a situation, we typically rely on a comparable firm (i.e., a firm with the same operating risk) that is traded on the exchange. If there is such a firm (or a group of such firms), we can estimate \( k_A \) for that firm and use it as an estimate for the \( k_A \) of the firm that we want to value (in our example, Coffee). Once we have this estimate of \( k_A \), we can follow the procedure from the previous section and find the WACC of our company by adjusting \( k_A \) by the debt tax shield under the target capital structure. 

 

For our example, suppose Bahia Beans is a comparable firm in the sense that it has the same operating risk. We know the following information about Bahia Beans (BB):

 

Bahia Beans's equity beta, \( \beta_{E, BB} \)

1.4

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

4%

Market risk premium, MRP

7%

 

Consequently, Bahia Beans's (BB) cost of equity is:

 

\( k_{E,BB}=R_F + MRP \times \beta _{E,BB} = 0.04 + 0.07 \times 1.4 \) = 13.8%.

 

Suppose we also know the following:

 

Bahia Beans's proportion of debt in the capital structure, D/(D+E)BB

65%

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

4%

Bahia Beans's debt rating

B+

Premium for B+ rated debt above the risk-free rate

3.7%

  

If so, as a first approximation, we can write:

 

\( k_{D, BB}=R_F + 0.037 = 0.04 + 0.037 \) = 7.7%.

 

Moreover, under the assumption that Bahia Beans's debt tax shield has the same risk as its assets, we can find it's \( k_A \) as follows:

 

\( k_A = k_{D,B} \times \big(\frac{D}{D+E}\big)_{BB} + k_{E,BB} \times \big(\frac{E}{D+E}\big)_{BB} = 0.077 \times 0.65 + 0.138 \times 0.35 \) = 9.84%.

 

Since Bahia Been and Coffee have the same operating risk, they also have the same \( k_A \). Consequently, Coffee's \( k_A \) is also 9.84%. To find its WACC, we want to compute:

 

\( WACC = k_A - k_D^* \times \tau_C \times \big(\frac{D}{D+E}\big)^* \).

 

We already have \( k_A \). All we need is its cost of debt and information about the capital structure. Suppose Coffee wants to maintain the original capital structure. In other words, suppose:

 

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

4%

Coffee's debt rating

A

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

2%

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%

 

If so, Coffee's (C) cost of debt equals:

 

\( k_{D,C} = R_F + 0.02 \) = 6.0%

 

This implies:

 

\( WACC = k_A - k_D \times \tau_C \times \frac{D}{D+E} = 0.0984 - 0.06 \times 0.3 \times 0.4 \) = 9.12%.

 

This section has illustrated how we can estimate the WACC of a company that does not have traded shares. As in the previous section, the trick was to find the \( k_A \) of that company. We found it by estimating \( k_A \) for a listed firm (or a group of firms) with the same operating risk. 

 

The trick of using the \( k_A \) of comparable firms can also be very useful when estimating the WACC for specific projects within a firm. The following two sections illustrate two typical applications of this procedure.