Business Analysis and

Valuation
Dr. Aprajita Pandey
BITS Pilani Department of Economics and Finance
Pilani Campus
 BITS Pilani
Pilani Campus

Estimating a Firm’s Cost of Capital

 Introduction

• The firm’s weighted average cost of capital (WACC) is the weighted

average of the expected after-tax rates of return of the firm’s various
sources of capital.
• A firm’s WACC can be viewed as its opportunity cost of capital, which
is the expected rate of return that its investors can earn from alternative
investment opportunities with equivalent risk.
• Firms regularly keep track of their WACC and use it as a benchmark
for determining the appropriate discount rate for investment projects,
valuing acquisition candidates, and evaluating their own performance.

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 Value, Cash Flows, and Discount Rates

• Cash flow calculations and discount rates must be properly aligned.

• If you are trying to estimate the value of the equity invested in the project, then you
will estimate equity-free cash flows and use a discount rate that is appropriate for
equity investors.
• On the other hand, if you are estimating the value of an entire firm, which equals the
value of the combined equity and debt claims, then the appropriate cash flow is the
combination of debt and equity cash flows. In that case, the appropriate discount rate
is a combination of the debt and equity holder rates, or what we refer to as the
weighted average cost of capital.
• Conservative cash flows- lower discount rate, Optimistic cash flows-higher discount
rate.

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 Defining a Firm’s WACC

• WACC is a weighted average of the after-tax costs of the various sources of invested
capital raised by the firm to finance its operations and investments.
• Invested capital as capital raised through the issuance of interest-bearing debt and
equity. Invested capital specifically excludes all non-interest bearing liabilities such
as accounts payable, as well as unfunded pension liabilities and leases, because we
will be calculating what is known as the firm’s enterprise value, which is equal to the
sum of the values of the firm’s equity and interest-bearing liabilities.
• WACC = (1-T) + +
• Note that the creditors receive a return equal to , but the firm experiences a net cost
of only (1-T).

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 Components of WACC

• Cost of Debt
• A bond is a long term debt instrument or security
• Main features of a bond are discussed below
• Face value
• Interest rate
• Maturity
• Redemption value
• Market value
• The expected cash flows consist of annual interest payments plus repayment of
principal.
• Can be classified in to three categories a) Bonds with maturity b) Pure discount
bonds and c) Perpetual bonds.

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 Components of WACC

• The discount rate is the interest rate that investors could earn on bonds with similar
characteristics
• By comparing the present value of a bond with its current market value, it can be
determined whether the bond is overvalued or undervalued.
• = + + +
• Yield to Maturity
• We can calculate a bond’s yield or the rate of return when its current price and cash
flows are known.

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• Yield to maturity is the measure of a bond’s rate of return that considers both
the interest income and any capital gain or loss. YTM’s is bond’s internal rate
of return.

883.4= + + + +

• We obtain YTM = 10 percent by trial and error.

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• It is, however, simpler to calculate a perpetual bond’s yield-to-maturity. It is equal to
interest income divided by the bond’s price
• Example if the rate of interest on Rs.1,000 par value perpetual bond is 8 per cent, and
its price is Rs.800, its YTM will be
• =
• = = 80/800 =0.10 or 10 percent
• The before tax cost of bond to the firm is affected by the issue price
• The lower the issue price, the higher will be the before tax cost of bond.
• The highly successful companies may sell bond or debenture at a premium; this will
pull down the before-tax cost of debt.

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Calculating the YTM of a firm’s debt is difficult for firms with a large amount of debt
that is privately held thus does not have market prices that readily available. Because
of this, it is standard practice to estimate the cost of debt using the yield to maturity
on a portfolio of bonds with similar credit ratings and maturity as the firm’s
outstanding debt.

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 Use Market weights

• With regard to the capital structure weights, it is important that the components used
to calculate WACC reflect the current importance of each source of financing to the
firm. This means that the weights should be based on the market rather than book
values of the firm’s securities because market values, unlike book values, represent
the relative values placed on the firm’s securities at the time of the analysis.

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 Use Market-Based Opportunity Costs

• Just as was the case with the capital structure weights, these costs should reflect the
current required rates of return, rather than historical rates at the time the capital was
raised. This reflects the fact that the WACC is an estimate of the firm’s opportunity
cost of capital today.

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 Use Forward-Looking Weights and
Opportunity Costs
• Firms typically update their estimate of the cost of capital periodically (e.g.,
annually) to reflect changing market conditions
• In most cases however, analysts apply WACC in a way that assumes that it will be
constant for all future periods
• It is reasonable to assume that the components of WACC are constant as long as the
firm’s financial policies remain fixed, financial policies sometimes change in
predictable ways over the life of the investment.

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 Example

• Office Mart finances 40% of its assets using debt costing 5%; equity investors in
companies similar to Office Mart ( in terms of both the industry and their capital
structures) demand a 14% return on their investment. Combining Office Mart’s after-
tax cost of borrowing (interest expense is tax-deductible and the firm’s tax rate is
20%) with the estimated cost of equity capital, we calculate a weighted average cost
of capital for the firm of 10% (i.e., 5% * [1-20%] * 0.4 + 14% * 0.6 = 10%).

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 Equity Valuation

• Firm FCF = Creditor Cash Flows + Equity FCF

• Equity FCF = Firm FCF – Creditor Cash Flows
• Creditor receive two types of cash flows: interest and principal
• The principal payments are cash inflows when the firm initiates new borrowing and
they are cash outflows when the firm repays debt. We can summarize the calculation
of creditor cash flows as follows:

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• Creditor Cash flows = Interest expense – Interest Tax savings + Principal payments-
New debt proceeds
• Equity FCF = Firm FCF- (Interest Expense – Interest Tax savings + Principal
Payments – New Debt Issue Proceeds).
• Equity FCF = Firm FCF – Interest expense + Interest tax savings – Principal
Payments + New debt proceeds.

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 Evaluate the Firm’s Capital Structure
Weights
• The first step in our analysis of WACC involves the determination of the weights
used for the components of the firm’s capital structure. These weights represent the
fraction of the firm’s invested capital, for example, the firm’s interest-bearing debt,
preferred equity, and common equity contributed by each of the sources of capital.
• In theory we should calculate weights using observed market prices for each of the
firm’s securities multiplied by the number of outstanding securities.

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• The market prices of equity securities are readily available, so an analysts can simply
multiply the current market price of the security by the number of shares outstanding
to calculate total market values.
• For debt securities, book values are often substituted for market values because
market prices for corporate debt are often difficult to obtain. When market values are
available, however, they should be used in place of book values.

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 Beta Unlevered

• A Publicly traded company that operates solely in the Maritime transport industry
has a marginal tax rate of 20% and a debt-to-equity ratio of 2.0. If the company’s
equity beta is 1.4, the unlevered beta of the business is closest to:
• A) 0.47
• B) 0.45
• C) 0.54

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 Re-levering Beta

Sure Freight, a company operating in the road transport business is considering a new
venture in the Maritime transport industry. The company has a marginal tax rate of
25% and a debt to equity ratio of 1.2. Sure freights debt is trading at a yield of 6.3%.
The unlevered beta computed in respect of a comparable business operating solely in
the Maritime transport industry is 0.54. If the risk-free rate is 4.2% and the expected
equity risk premium is 5.6%, the correct WACC to use in evaluating Sure Freight’s
venture in the maritime transport business is closest to:
A) 7.08%
B) 7.52%
C) 8.04%

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