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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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CALCULATION PITFALLS

WACC is a market-weighted average, at target leverage, of the cost of after-tax debt and equity. We estimate the cost of equity as Rf + beta × MRP, where Rf is the riskless return, market risk premium (MRP) is the expected return premium for bearing equity market risk over the riskless rate, and beta is the systematic risk of the business relative to the market. Estimation of these key inputs (riskless rate, the market risk premium and beta), or degrees of freedom, can lead to a wide range of outcomes.

We normalize the riskless rate with a forward view of the capital markets. We continue to believe that 5 percent is a reliable estimate of the MRP, based on historical data and forward-looking market data.1 We will provide tools for deriving more reliable estimates of beta in the most problematic areas. This will be especially helpful for business units, unlisted companies, and illiquid stocks with unreliable betas. Direct regression is the most commonly used approach but we also employ alternative methodologies such as constructed betas, portfolio betas, segment regression betas, and multi-variable regression betas.

Beyond these key inputs, the most common pitfalls regard the weightings of debt and equity.

  • Financing events per se may not reflect changes in financial policy and may not be permanent changes to the capital structure. Temporary fluctuations in the mix should not affect WACC.
  • The WACC for financial institutions is (generally) the cost of equity, ...

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