How to Calculate WACC for Private (Unlisted) Companies?
Dec 4
/
themodelingschool
What is WACC?
WACC is the average rate of return a company must pay to its equity and debt investors. It combines the cost of equity and the cost of debt, weighted by their proportion in the company’s capital structure. The formula is:
WACC = (E / V) * Re + (D / V) * Rd * (1 - t)
Where:
- E: Market value of equity
- D: Market value of debt
- V = E + D: Total value of the company
- Re: Cost of equity
- Rd: Cost of debt
- t: Corporate tax rate
Step-by-Step Guide to Calculating WACC for Private Companies
1. Estimate the Cost of Equity (Re)
The cost of equity represents the return required by equity investors. For private companies, we estimate Re using the Capital Asset Pricing Model (CAPM):
Re = Rf + β * (Rm - Rf) + Size Premium
Components of CAPM:
- Risk-free rate (Rf): Use yields on government bonds (e.g., 10-year treasury bonds) as a proxy.
- Market risk premium (Rm - Rf): Reflects the historical premium of stock market returns over risk-free returns, typically 5%-6%.
- Beta (β): Adjust beta for the private company’s capital structure:
Beta_unlevered = Beta_levered / (1 + (D / E) * (1 - t))
Beta_private = Beta_unlevered * [1 + (D / E) * (1 - t)]
Example:
Assume a private manufacturing company has:
- Rf = 3% (10-year treasury yield)
- Industry beta = 1.2
- Debt-to-equity ratio = 0.5
- Tax rate = 25%
Unlever Beta Calculation:
Beta_unlevered = 1.2 / (1 + 0.5 * (1 - 0.25)) = 0.96
Re-lever Beta Calculation:
Beta_private = 0.96 * [1 + 0.5 * (1 - 0.25)] = 1.2
Cost of Equity:
Re = 3% + 1.2 * 5% + 2% = 11%
2. Estimate the Cost of Debt (Rd)
The cost of debt is the interest rate a company pays on its debt. For private companies, use:
- The average interest rate on existing debt (if known).
- Industry benchmarks for similar companies’ debt.
Adjust for Taxes:
Rd = Pre-tax Cost of Debt * (1 - t)
Example:
If the company’s average interest rate is 8% and its tax rate is 25%, the after-tax cost of debt is:
Rd = 8% * (1 - 0.25) = 6%
3. Determine the Capital Structure (E and D)
Private companies lack market values for equity (E) and debt (D), so estimates are required:
- Equity Value (E): Use valuation multiples (e.g., EV/EBITDA, P/E) from comparable public companies.
- Debt Value (D): Use book values from the company’s balance sheet as a proxy.
Total Value: V = E + D
4. Calculate WACC
Substitute the values into the WACC formula:
WACC = (E / V) * Re + (D / V) * Rd * (1 - t)
Example:
Assume:
- E = 60M, D = 40M
- Re = 11%, Rd = 6%
- Tax rate = 25%
Total Value: V = E + D = 60M + 40M = 100M
WACC = (60 / 100) * 11% + (40 / 100) * 6% * (1 - 0.25) = 9%
Practical Considerations
1. Data Reliability: Cross-check assumptions with industry data wherever possible.
2. Lack of Marketability Discount (LOMD): Adjust equity valuations for illiquidity. This discount typically ranges from 15%-30%.
3. Sensitivity Analysis: Test different assumptions to understand the impact on WACC.
Conclusion
Calculating WACC for private companies requires careful estimation and industry benchmarking. By following the steps outlined above, you can develop a reasonable estimate tailored to the unique circumstances of a private firm. Use WACC alongside other financial metrics to make informed decisions.
