VANDELAY INDUSTRIES WACC EXAMPLE.

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Presentation transcript:

VANDELAY INDUSTRIES WACC EXAMPLE

How to use the set of tools developed here to select discount rates for capital budgeting. Select a publicly traded company that is comparable in terms of the risk of the underlying business assets. Obtain the unlevered (asset) beta of the comparable. Obtain the corresponding project equity beta for your firm, reflecting your firm’s capital structure. Obtain the cost of equity and cost of debt for this project at your firm. Calculate the WACC for the project and calculate NPV.

NO! Vandelay Industries VI is an architectural and construction firm with operations in design, development, and management of commercial real estate. VI’s equity beta is 1.0. VI has and will maintain a debt/equity ratio of 1.0. Can we use the company cost of capital to value a new import-export business opportunity with the following annual cashflows? 0 1 2 3 4 5 -26.0 3.98 5.42 6.68 5.99 22.46 NO! Latec Inc. is an import-export company that only has operations in this industry. Latec’s equity beta is 1.35. Latec has a debt to equity ratio of 0.75, and a marginal tax rate of 45%.

Delevered Betas with debt/equity ratios The formulas for obtaining asset betas from equity betas and vice versa provided earlier required dollars values for debt (D) and equity (E). What if you are only given the leverage ratio, L = D/E?

Delever Latec’s Beta to obtain the Beta of import/export assets: Latec has L =0.75, TC = .45, and an equity beta of 1.35. Note that L=D/E!

Relever the asset Beta to reflect VI’s capital structure Recalling that VI will keep its debt/equity ratio equal to one, we can get: This is the beta for a VI equity position in an import-export business.

Vandelay Industries Assume that the risk free rate is 8% and that VI’s cost of debt is also 8%. The market risk premium is 7%. The required return on VI’s equity is: The weighted average cost of capital for the importing venture (using the fact that B/S = 1 here) is:

Finally, we can evaluate the NPV of the import-export venture using the WACC that reflects the risk associated with this particular business. Given the following cashflows for years 1 thru 5 and an initial investment of $26 million. So, the NPV is positive, proceed with the import-export business. Notice that the selected discount rate of 11.38% reflects: The risk (beta) of import-export businesses, not VI’s existing businesses. VI’s capital structure, not that of the surrogate firm.

Questions VI’s equity beta prior to starting the import-export business was 1.0 (levered beta). What will happen to the beta of VI after starting the new business? Suppose that VI uses the firm’s cost of capital to evaluate the importing business? Would this favor the investment? Does VI diversifying into the import-export business help shareholders by providing them a more diversified portfolio?