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Victoria analyzes Acme‟s audited financial statements—including the footnotes—and interviews
management on the firm‟s current borrowing rates for its long-term financing. Based on her analysis,
she estimates the firm‟s current borrowing rate is 9%. Since interest is a business expense that reduces
tax income, the effective interest rate is less than 9%. Victoria finds that Acme has a 40% tax rate.
Therefore, she finds Acme‟s after-tax cost of debt is 5.4%, as presented in Exhibit 16.9.
Weighted Average Cost of Capital
Victoria estimates that Acme‟s optimal capital structure is 40% debt and 60% equity. She bases her
findings on the average capital structures of public firms in the same industry as Acme and then
considers that Acme does not have the same access to equity capital as do public firms.
Based on this weighting between debt and equity, Victoria estimates Acme‟s weighted average cost
of capital at 13.3%. The calculation is presented in Exhibit 16.10.
Discounted Cash Flow Calculation
As discussed earlier, Acme‟s forecasted net cash flows for 2009 to 2013 are discounted to a present
value as of the December 31, 2008, valuation date. The discount rate Victoria uses is Acme‟s
weighted average cost of capital of 13.3%. In addition, Acme‟s residual value as of December 31,
2013, is discounted to a present value using the same discount rate.
Victoria prepares Exhibit 16.11, which shows the discounting of the cash flows for the five-year
period and the discounting of the residual value. Her calculations assume that the annual cash flows
are earned equally during each year. Therefore, the present value calculation for the annual cash flows
uses the middle of each year—June 30—for the discounting computations. For instance, the first
forecasted year (2009) is discounted one-half year—rather than one full year—to the valuation date of
December 31, 2008.
Exhibit 16.10 Acme Manufacturing, Inc.: Weighted cost of capital.
Exhibit 16.11 Acme Manufacturing, Inc.: DCF method of valuation as of December 31, 2008.