## Reading: Practical Implementation

View

### 1. Introduction

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:

1. 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.

2. Overall cost of capital: Estimate the overall cost of capital, $k_A$, for the comparable firm:
• Cost of equity ($k_E$) using the Capital Asset Pricing Model (CAPM)
• Cost of debt using bond yields
• Debt and equity ratio using market data (market value of equity) and the book value of debt.

3. The overall cost of capital $k_A$ 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 $k_A$ from step 2 is the relevant $k_A$ for the firm/project we want to value.

4. Adjust $k_A$ 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.