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

1.5. Situation E: Firm Operates in Multiple Industries

Finally, we are sometimes also confronted with the valuation of unlisted projects or firms that have multiple types of operating risks. To illustrate how to estimate the WACC of such projects (or firms), let's assume that Coffee has a project that is 40% in Farming and 60% in a completely new field for the firm (for example Water supply). Here is how to proceed:

 

  • Step 1: Identify comparable companies in the respective business segments:
    • Farming: In the previous section, we have assumed that Grow is a comparable company for the farming division.
    • Water supply: Let's assume that there is a company Splash that operates in water supply.

 

  • Step 2: Estimate the overall cost of capital (\( k_A \)) of the comparable companies in the various business segments:
    • Farming: According to our assumptions in the previous section, \( k_{A,Grow} \) is 8%.
    • Water supply: Let's assume that Splash's overall cost of capital \( k_{A,Splash} \) is 11%.

 

  • Step 3: Use these estimate as proxies for the overall cost of capital of your firm's business activities. That is:
    • \( k_{A,Farming} = k_{A,Grow} \) = 8%.
    • \( k_{\text{A, Water supply}} = k_{\text{A, Splash}} \) = 11%

  

  • Step 4: To find the overall cost of capital of the project, compute a weighted average of the overall costs of capital of the various business activities. Assuming the relevant weights for farming and water supply are 40% and 60%, respectively, we find the project's \( k_A \) as:

 

\( k_{A, Project} = weight_{Farming} \times k_{A,Farming} + weight_{\text{Water supply}} \times k_{A,\text{Water supply}} = 0.4 \times 0.08 + 0.6 \times 0.11 \) = 9.8%.

 

  • Step 5: Incorporate the firm's target capital structure to estimate the project's WACC (\( WACC_{Project} \)). Assuming the same financing policy for Coffee as in the previous sections (\( k_D \) = 6%; \( \tau_C \) = 30%; Target debt ratio = 40%), we can find a WACC of:

 

\( WACC_{Project} = k_{A, Project} - k_D \times \tau_C \times \frac{D}{D+E} = 0.098 - 0.06 \times 0.3 \times 0.4 \) = 9.08%.

  

This section has shown how to estimate the WACC of a company that operates in multiple industries.