Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be...

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect each component of the weighted average cost of capital (WACC). What mistakes are commonly made when estimating the WACC, and how do these mistakes arise?

Expert Solution

The main responsibilty of Federal Reserve Bank is to stabalize the long-term interest rates. This they achieve by changing the Fed rate and changing the money supply in the system. This cause change in risk free rate which in turn is a crucial component of calculating cost of debt (Kd) and Cost of equity (Ke)

If Rf increases, Banks will also increase the interest rates and cost of debt for business will increase.

Also, as per CAPM Model:

Ke = Rf + Beta * Market risk premium

So change in Rf will change the cost of equity

These can be multiple issues and mistakes which can happen while calculating the WACC:

1. Wrong use of risk free rate : Some time, we use historical rate or short term govt security rate as risk free which is not proper Rf and WACC estimation become flawed.

2. Wrong Beta : Some time, we made mistake which calculating beta value, or we used unlevraged beta instead of using levraged one etc. This all lead to wrong WACC

3. Wrong Market risk premium : Sometims we take make mistakes in estimating market return which lead to mistake in market risk premium and which inturn lead to wrong WACC

jeff jeffy answered 2 years ago

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be...

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect each component of the weighted average cost of capital (WACC). What mistakes are commonly made when estimating the WACC, and how do these mistakes arise?

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be...

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect each component of the weighted average cost of capital (WACC). What mistakes are commonly made when estimating the WACC, and how do these mistakes arise? Please list and describe four to five.

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be...

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect each component of the weighted average cost of capital (WACC). What mistakes are commonly made when estimating the WACC, and how do these mistakes arise?

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Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be...

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