2. Example

Let us consider a fictitious German company ERPsli, which wants to introduce a novel ERP system. Since the project is not listed, we do not have the data to directly measure ERPsli's systematic risk and cost of capital.

 

To estimate ERPsli's WACC, we follow the procedure outlined before:

  1. Identify comparable firm
  2. Estimate the comparable's \(k_A\)
  3. Assume ERPsli has the same \(k_A\) 
  4. Adjust \(k_A\) to reflect ERPsli's financing policy and thereby estimate ERPsli's WACC.

   

(1) Comparable Firm: SAP

For the purpose of illustration, let us assume that the German software giant SAP is an appropriate comparable company. Therefore, we first estimate SAP's \(k_A\) and then adjust that WACC for the specific financing policy of ERPsli.

  

(2) SAP's Overall Cost of Capital \((k_{A,SAP})\)

Next, we estimate SAP's overall cost of capital. To do so, we have collected the following information:

  

Variable Description Value
\(R_F\) Risk-free rate of return 0.2%
\(MRP\) German's market risk premium 5.0%
\(\beta_{E,SAP}\) SAP's equity beta 1.1
\(k_{D,SAP}\) SAP's cost of debt (bond yield) 0.9%
\(\frac{D}{D+E}_{SAP}\) SAP's debt ratio 20%
\(\frac{E}{D+E}_{SAP}\) SAP's equity ratio 80%

 

With all this information, we can estimate's SAP's overall cost of capital, kA, of 4.7%:
 

Cost of equity: \(k_{E,SAP} = R_F + \beta_{SAP}\times MRP = 0.002 + 1.1 \times 0.05 = 0.057 = 5.7\%\)

 

Overall cost of capital: \( k_{A,SAP} = k_{D,SAP} \times \frac{D}{D+E}_{SAP} + k_{E,SAP} \times \frac{E}{D+E}_{SAP} \) \(=0.009 \times 0.2 + 0.057 \times 0.8 = 0.0474 = 4.74\%\)
 

(3) Assume that ERPsli has the risk as SAP because it operates in the same business

Consequently, we assume that ERPsli and SAP have the same overall cost of capital:

 

\( k_{A,SAP} = k_{A,ERPsli} = 4.74\% \)

 

(4) Estimate ERPsli's WACC given the firm's specific financing policy

Now we can incorporate the tax effects of financing that result from ERPsli's specific financing policy. To do so, let us assume the following:

 

Variable Description Value
\(k_{D,ERPsli}\) ERPsli's cost of debt 1.2%
\(\tau_C\) Corporate tax rate 30%
\(\frac{D}{D+E}_{ERPsli}\) ERPsli's debt ratio 40%

  

With this information, we can estimate ERPsli's WACC of 4.6%:

  

\(WACC_{ERPsli}=k_A - k_{D,ERPsli} \times \tau_C \times \frac{D}{D+E}_{ERPsli}\) \(= 0.0474-0.012 \times 0.3 \times 0.4 = 0.0460 = 4.60\% \)

 

Based on all the available information, we therefore estimate a WACC of 4.6% for ERPsli. As we have discussed already before, we should keep in mind that all the ingredients of this calculation could be subject to measurement error, which is why we should think about a potential value interval for the WACC before finalizing ERPsli's valuation...

  

Importantly, this section has illustrated how we can, in principle, obtain the WACC of any firm or project using comparable firms for which we can find the necessary data. 

 

In the course module Cost of Capital and Valuation, we extend these considerations to a set of additional valuation situations.