Business Valuation 613Required Discount Rate (Rate of Return)
As previously discussed, since ACME is being analyzed on a debt-free basis,
Victoria uses the weighted average cost of capital (WACC) as the discount rate.
The WACC incorporates the cost of debt and the cost of equity using market
evidence and weights them based on capital structure. Each element of the
weighted average cost of capital as it applies to ACME is discussed in the fol-
lowing sections.
Cost of Equity
As discussed earlier in this chapter, an investor has many places to invest his or
her funds. A rational investor expects a higher rate of return when an invest-
ment carries more risks. In developing ACME’s rate of return on equity capi-
tal, Victoria uses the modified capital asset pricing model (CAPM) that is
defined as:
Equity rate of return Risk-free rate Equity risk premium Beta)
Size risk premium Specific company risk premium=+ ×
++(EXHIBIT 18.7 ACME Manufacturing Inc.: Projected balance sheets
2001–2005.
Adjusted ($million)
2000 2001 2002 2003 2004 2005Cash $ 0.04 $ 0.20 $ 0.20 $ 0.23 $ 0.24 $ 0.40
Accounts receivable 6.87 7.69 8.61 9.55 10.61 11.67
Inventory 4.45 4.98 5.58 6.19 6.88 7.56
Other current assets 0.34 0.38 0.42 0.47 0.52 0.57
Total current assets 11.69 13.24 14.81 16.44 18.24 20.20
Fixed assets 14.34 17.14 20.08 23.16 26.40 29.80
Accumulated depreciation (2.94) (3.82) (4.83) (5.97) (7.26) (8.69)
Net fixed assets 11.40 13.32 15.25 17.19 19.15 21.12
Other assets 1.33 1.47 1.61 1.77 1.95 2.15
Total assets $24.42 $28.03 $31.67 $35.41 $39.34 $43.46
Accounts payable $ 4.55 $ 5.12 $ 5.74 $ 6.37 $ 7.07 $ 7.77
Notes payable — 0.30 0.26 — — —
Current portion LTD 4.58 3.28 3.45 3.63 3.85 4.07
Other current liabilities 2.37 2.66 2.97 3.30 3.66 4.03
Total current liabilities 11.50 11.35 12.42 13.29 14.58 15.87
Long-term debt 5.83 7.65 8.04 8.46 8.98 9.49
Total liabilities 17.33 19.00 20.46 21.75 23.57 25.36
Equity 7.09 9.03 11.21 13.66 15.77 18.10
Total liabilities & equity $24.42 $28.03 $31.67 $35.41 $39.34 $43.46