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Federal Reserve increases interest rates, what impact would this have on firms WACC and their investment...

Federal Reserve increases interest rates, what impact would this have on firms WACC and their investment activit

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Expert Solution

Weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds and any other long-term debt.

WACC = Cost of Equity * (Equity/ (Debt +equity + Preferred shares)) +

Cost of Debt * (Debt/ (Debt +equity + Preferred shares))* (1 -Tax Rate) +

Cost of Preferred shares * (Preferred shares / (Debt +equity + Preferred shares))

As interest rates effects the risk-free rate which is used by investors to calculate cost of equity (Expected rate of return for an investment) using CAPM ((Rf + (Rm – Rf) * β).

This can affect a firm's WACC because the risk-free rate is an important factor in calculating the cost of capital. Interest rate are inversely proportional to bond price. As the interest rate on debt price fluctuates, making difficult for a company to predict the future costs of capital. This may result in company ending up with greater or lesser capital costs than expected. A firm's cost of debt must be updated frequently as the cost of debt reacts to fluctuations in interest rates.
For investors it become difficult to value company as cost of equity i.e. required return is also used as discount factors in valuation methods, GGM, Free cash flow etc.

jeff jeffy answered 2 years ago
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