AFMP4
Syllabus B3cd. The Cost of CapitalAdvanced cost of capital

WACC calculated using Asset Beta 1 / 2

Use when the business risks change

Steps:

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

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

  3. Calculate your MVe and MVd

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

  5. Calculate Ke using CAPM

  6. 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

  1. 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

  2. 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•217

    Other activities:
    MVe = 75% x $480m = $360
    MVd = 80% x $96 = $76.8

    Elfu Co asset beta of other activities = 
    1•25 x $360m/($360m + $76•8m x (1 – 0•25)) = 1•078

    Assuming 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

  3. Calculate your MVe and Mvd

    MVe of Tisa Co = 10 million shares x 180c = $18m
    Mvd of Tisa Co = $3.6m

  4. 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

  5. Calculate Ke using CAPM

    Component Ke = 3•5% + 1•879 x 5•8% = 14•40%

  6. 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%