Question

 

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?

Answer 1

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. It is calculated by multiplying the cost of each capital source by its relevant weight, and then adding the products together to determine the WACC value.

Internal and external factors can cause problems for investors and analysts trying to assess the performance of a firm over time and in comparison with other firms in the industry. One external factor is the fluctuation of interest rates. The Federal Reserve Bank (the Fed) moderates long-term interest rates by targeting the federal funds rate - the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank overnight.

The Fed attempts to align the effective federal funds rate with the targeted rate by making additions to or subtractions from the money supply through open market operations (the buying and selling of U.S government securities, or Treasury bills).

As interest rates are moderated, it can cause fluctuations in the risk-free rate, the theoretical rate of return for an investment that has no risk of financial loss. This can affect a firm's WACC because the risk-free rate is an important factor in calculating the cost of capital. As the interest rate on debt fluctuates, it can be challenging for a company to predict the future costs of capital. As a result, a company can end up with greater or lesser capital costs than expected because of fluctuations in interest rates. A firm's cost of debt must be updated frequently as the cost of debt reacts to fluctuations in interest rates.

Other external factors that can affect WACC include corporate tax rates, economic conditions, and market conditions

Mistakes to avoid:

1.Using the existing coupon rate as the current cost of debt. The correct cost is the current YTM.

2. Using the book value as the weights in WACC. The correct weights to use are the target capital structure and it that is not available, to use the market value as weights.

3. Using sources of capital which do not come from investors. The correct way is to use only those sources of capital that come from investors.

4.

When estimating the risk premium for the CAPM approach, don't subtract the current long-term t-bond rate from the historical average return on stocks.