Monday, November 11, 2013

Weighted Average Cost Of Capital for an uncharacteristic project

Honestly here is the sort of calculation that you want to circle, then come back to if you have enough time.

Refried Bean Company (RBC) is considering a project in the high-end hotdog business. Its debt currently has a yield of 10%. Degen has a leverage ratio of 2.5 and a marginal tax rate of 40%. Luxury Hotdogs Inc. (LHI), a publicly traded firm that operates only in the high-end hotdog business, has a marginal tax rate of 30%, a debt-to-equity ratio of 2.5, and an equity beta of 1.2. The risk-free rate is 4% and the expected return on the market portfolio is 10%. Calculate the appropriate WACC to use in evaluating the Refried Bean Company's boutique schnitzel project.

This is just a WACC problem with a twist. Instead of calculating the WACC with the cost of equity, we need to calculate a "project cost of equity" and add it to RBC's cost of debt. We get the project cost of equity from the risk free rate, plus the Project Beta times the difference between the return on the market portfolio, and the risk free rate: The Project Beta is derived from LHI's Asset Beta, which we can find using figures given.

Step one, find LHI's asset beta: Basset = company beta[1 / (1 + (1 - LHI's tax rate)( LHI's debt to equity ratio))]  = 1.2[1 / (1 + (1 - 0.30)(2.5))] = 0.28

Step two, find RBC's equity beta for this project: Bequity = Basset[1 + (1 - RBC's tax rate)(LHI's equity beta)] = 0.28[1 + (1 - 0.4)(1.2)] = 0.48

Step three, find the project cost of equity: 4% + 0.48(10% - 4%) = 6.9%

Step four, find RBC's cost of debt: 10%(1 - 0.4) = 6%

Step five, find the weight of RBC's debt and equity: Wdebt = 0.6 and Wequity = 0.4

Step six, solve for the project's WACC: 0.6(6%) + 0.4(6.9%) = 3.6 + 2.76 = 6.36%

Like most problems, the hardest part is getting started. I always get mixed up with step one and two, but with some practice it isn't as impossible as it seems.

Now a word of caution, yesterday I didn't really know how to do this. There is a good chance I've made mistakes, if you see one, please comment.