### Use when the business risks change

#### Steps:

Calculate competitor's Market Value of equity and Market Value of debt

Use competitor’s information to estimate the project’s asset beta (includes business risk of the competitor only)

Calculate your MVe and MVd

Then based on your capital structure, estimate the project’s equity beta (includes business risk of the competitor and your financial risk).

Calculate Ke using CAPM

Calculate WACC

#### Exam standard example (extract)

Tisa Co is considering an opportunity to produce an innovative component.

This is an entirely new line of business for Tisa Co. (**New business risk**)

Tisa Co has 10 million 50c shares trading at 180c each.

Its loans have a current value of $3•6 million and an average after-tax cost of debt of 4•50%.

Tisa Co’s capital structure is unlikely to change significantly following the investment. (**No change in Financial risk**)

Elfu Co manufactures electronic parts for cars including the production of a component similar to the one being considered by Tisa Co.

Elfu Co’s equity beta is 1•40, and it is estimated that the equivalent equity beta for its other activities, excluding the component production, is 1•25.

Elfu Co has 400 million 25c shares in issue trading at 120c each.

The loans have a current value of $96 million.

It can be assumed that 80% of Elfu Co’s debt finance and 75% of Elfu Co’s equity finance can be attributed to other activities excluding the component production.

Tax 25%.

Risk free rate 3•5%

Market risk premium 5•8%.

**Required**

Calculate the cost of capital that Tisa Co should use to calculate the net present value of the project.

#### Solution

**Calculate competitor's Market Value of equity and Market Value of debt**Elfu Co MVe = $1•20 x 400m shares = $480m

Elfu Co MVd = $96m**Use competitor’s information to estimate the project’s asset beta (includes business risk of the competitor only)**Asset Beta = Equity Beta x (E / (E + D(1-tax))

Elfu Co portfolio asset beta for ALL activities =

1•40 x $480m/($480m + $96m x (1 – 0•25)) = 1•217Other activities:

MVe = 75% x $480m = $360

MVd = 80% x $96 = $76.8Elfu Co asset beta of other activities =

1•25 x $360m/($360m + $76•8m x (1 – 0•25)) = 1•078Assuming that:

25% can be attributed to component activities and

75% can be attributed to other activities:1•217 = component asset beta x 0•25 + 1•078 x 0•75

Component asset beta = [1•217 – (1•078 x 0•75)]/0•25 = 1•634

**Calculate your MVe and Mvd**MVe of Tisa Co = 10 million shares x 180c = $18m

Mvd of Tisa Co = $3.6m**Then based on your capital structure, estimate the project’s equity beta (includes business risk of the competitor and your financial risk).**Equity Beta = Asset Beta x ((E + D(1-tax) / E)

Component equity beta based on Tisa Co capital structure =

1•634 x [($18m + $3•6m x 0•75)/$18m] = 1•879**Calculate Ke using CAPM**Component Ke = 3•5% + 1•879 x 5•8% = 14•40%

**Calculate WACC**Ke = 14.40%

Kd = 4.5% (after tax)Component WACC = (14•40% x $18m + 4•5% x $3•6m)/($18m + $3•6m) = 12•75%