Reading: Practical Implementation

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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.