Reading: Practical Implementation
In this example, let us consider a constellation that is relevant for most firms:
- A firm wants to estimate the cost of capital to value a project.
- However, the shares of the firm are not publicly traded, so there is no way to directly estimate the necessary risk parameters to determine the cost of capital.
- What could the firm do?
Here is what the firm could do:
- Comparable firm: Look for a listed firm (or a group of listed firms) with a similar business model, for which we have the necessary data to estimate the systematic risk.
- Overall cost of capital: Estimate the overall cost of capital, , for the comparable firm:
- The overall cost of capital is driven by the operating business risk. If the comparable firm has a similar business model as the firm/project we want to value, it is fair to assume that the comparable's overall cost of capital is similar to that of the firm/project in question.
Consequently, assume that the resulting from step 2 is the relevant for the firm/project we want to value.
- Adjust for the specific financing policy of the firm/project in question to obtain a firm/project specific WACC.
This is the general procedure to estimate the WACC of any firm.
Let us practice this with an example.