Question

•What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate?

•How should we factor flotation costs into our analysis?

Answer 1

What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate?

Method 1:

• Identify the peerset (other companies) offering the similar product or service as your company under consideration
• Calculate the beta of each of the companies and then take an average
• Use that as beta for your own company under consideration
• Calculate cost of equity using CAPM and use the same as discount rate for the project

Method 2:

• Estimate the firm's WACC.
• If the project is riskier than the overall firm, then use the project WACC as a value > firm's WACC
• If the project is less riskier than the overall firm, then use project WACC as a value < firm's WACC

How should we factor flotation costs into our analysis?

Wherever price is used for calculation we should consider the price net of flotation cost. Say for example:

• In case of stock, we calculate cost of equity as Ke = D1 / P + g. If there is flotation cost F% then use P x (1 - F) in stead of F in the above equation. That means, Ke = D1 / [P x (1 - F)] + g
• Similalrly, in case of bonds, use Price net of flotation cost instead of pure price, to calculate the YTM