Wacc Homework

WACC Homework

1. Which WACC?

1. So far, we have generally talked about valuing companies on a “stand-alone” basis. In the context of M&A transactions, we really want to be thinking about the value of the company from the perspective of different potential buyers. When you are valuing a company that you want to acquire, whose WACC (whose cost of debt and required return on equity) should you use, yours (the acquirer) or the target company’s?  (check one)

The acquirer’s WACC ___

The target company’s current WACC _Check__

1. For what reason(s) would you adjust the WACC in valuing the target company?

2. Private Equity firm’s WACC

Let’s look at the WACC for the average private equity buyer. Based on the data presented in the first class, the average private equity M&A transaction in Q2 2015 was purchased at a multiple of 7.6x EBITDA and was financed with 4.8x debt and 2.8x equity. Let’s assume that the debt was composed of 3.8x senior debt and 1.0x subordinated (or mezzanine) debt. Use these multiples to calculate the ratio of each kind of capital for calculating the weighted-average. For example, 1.0/7.6 = 13.16%, so the WACC calculation would include a weighting of 13.16% * the cost of subordinated debt * (1 – corporate tax rate) to account for the contribution of the subordinated debt to the private equity firm’s WACC.

Currently, the typical cost of senior debt in a highly leveraged transaction is approximately 400 basis points above 3-month LIBOR, with a LIBOR floor of 1.0%. The cost of subordinated debt typically ranges between 11% - 15%; let’s assume 13% for this homework (all taxable). Let’s assume an effective corporate tax rate of 35%.

The actual net return (net of fees and carried interest) to investors (limited partners) in private equity funds over the last 20 years is an annualized return of 13.45% (see Cambridge Associates Q1 2015 report being posted in Latte for week 5), but let’s assume that the private equity firms themselves are targeting a 20% return on their equity when they make investments.

1. Using the above information, calculate the WACC for a typical private equity-backed acquisition.

Portion of equity: 2.8/7.6=36.84%

Portion of senior debt: 3.8/7.6=50%

Portion of subordinated debt: 1.0/7.6=13.16%

36.84%*20% + 13.16%*13%*(1-35%)+50%*5%*(1-35%)= 10.11%

...