WACC in Specific Valuation Situation

In the previous section, we have learned how to work with comparable firms when estimating the WACC of a firm that is not traded. The same challenge typically arises when valuing individual projects within a firm (regardless of its listing status). The reason is that individual projects are generally not listed on a stock exchange. Moreover, they might have risk characteristics that differ from those of the overall firm.

To illustrate the resulting problem and a possible solution, suppose Coffee has two divisions with different risk characteristics: Farming and Processing. Also suppose the Farming division wants to do a new project. What's the relevant WACC for this project (\( WACC_{Farming} \))? 

As long as Farming has the same risk characteristics as the whole firm Coffee, we can use (\( WACC_{Coffee} \)) as a discount rate for the project's free cash flows. In many instances, however, different divisions will have different operating risks. In these situations, the cost of capital of the overall firm (\( WACC_{Coffee} \)) will no longer be an adequate estimate of the cost of capital of the division in question (\( WACC_{Farming} \)).

To get around this problem we should proceed as follows:

• Step 1: Find a company (or a group of companies) that has the same operating risk as the farming division. Most likely, this will be a company that deals exclusively in farming. Suppose the hypothetical company Grow is such a company. 

• Step 2: Estimate the overall cost of capital for the comparable company (\( k_{A,Grow} \)). To do so, we follow the exact same procedure as in the previous sections, when we used a comparable company (Bahia Beens) to estimate the firm's cost of capital. Let's assume that this procedure implies a cost of capital of 8% for Grow (\( k_{A,Grow} \)).

• Step 3: Use the comparable firm's \( k_A \) as a proxy for the \( k_A \) of the project in question: \( k_{A,Grow} = k_{A, Farming} \).

• Step 4: Incorporate the firm's target capital structure to estimate the divisional WACC (\( WACC_{Farming} \)). Assuming the same financing policy for Coffee as in the previous section (\( k_D \) = 6%; \( \tau_C \) = 30%; Target debt ratio = 40%), we can find a WACC of:
   

Dealing with non-operating assets

The approach outlined above is also helpful when valuing projects in firms with significant non-operating assets (or liabilities) such as excess cash, real estate, or pension liabilities. These assets and liabilities are part of the firm's overall risk profile and therefore affect the firm's overall WACC as estimated in the preceding chapter. To find the WACC of the operating activities, we consequently have to adjust the overall WACC for the risk and exposure of the non-operating assets. To do so, we can treat the non-operating assets as individual "divisions" (to use the language from above) and follow the procedure outlined above to extract the cost of capital of the operating business.

A case in point is Apple.

• In early 2017, the firm had a market value (debt plus equity) of approximately USD 900bn and its overall cost of capital, \( k_{\text{A}} \) was approximately 10%. 
• According to the 2016 annual report, the firm had non-operating investments with a book value of approximately USD 250 billion. Let's assume these non-operating investments carry a cost of capital of 6% (\(k_{\text{A, NO}}\)). 
• Based on this information, what's the cost of capital of the firm's operating business?

Using the logic from above, Apple is a portfolio of operating activities (USD 650 bn) and non-operating activities (USD 250 bn). If the overall cost of capital is 10%, the weighted average of the cost of capital of the operating and the non-operating activities must be 10% as well:

\( k_A = k_{A, O} \times \frac{V_O}{V_O + V_{NO}} + k_{A, NO} \times \frac{V_{NO}}{V_O + V_{NO}} \),

where O denotes the operating business, NO denotes the non-operating business, and V reflects the market value of the respective activities.

To extract the cost of capital of the firm's operating activities, \(k_{A, O}\), we can solve this expression as follows:

\(k_{A, O} = k_A + (k_A - k_{NO}) \frac{V_{NO}}{V_O}\)

Using the numbers from above, this would imply an overall cost of capital of 11.5% for Apple's operating business:

\(k_{A, O} = k_A + (k_A - k_{NO}) \times \frac{V_{NO}}{V_O} = 0.1 + (0.1 - 0.06)\times \frac{250}{650} \) = 11.5%.

This is the cost of asstes the firm should use as a starting point to estimate the WACC for operating investment decisions. If the firm used its firm-wide cost of capital of 10% instead, it would underestimate the actual cost of capital of the project, which, in turn, would lead to an upward bias in the valuation estimation. 

Apple's cost of operating assets of 11.5% (\(k_{A, O}\)) is also the relevant starting point to estimate the cost of capital of a comparale firm that operates in the same industry as Apple.