Question

1. The weighted average cost of capital (WACC) is calculated as the weighted average of cost of component capital, including debt, preferred stock and common equity. In general, debt is less expensive than equity because it is less risky to the investors. Some managers may intend to increase the usage of debt, therefore increase the weight on debt (W_d). Do you think by increasing the weight on debt (W_d) will reduce the WACC infinitely? What are the benefits and costs of using a lot of debt?

2. Do you think it is necessary for a firm to adjust its overall WACC according to the risk of each individual project? Why? If a firm insists that it will use only one WACC to evaluate all its projects, what would be the consequence in the long term?

Answer 1

1.Do you think increasing the weight of debt will reduce WACC infinitely ?

Answer : Cost of Procurement of debt is much less as compare to common equity due to lower risk and fixed return in form of interest but increase in weight of debt will result in HIGHER INTEREST RATE to procure the debt with the increase in risk of default. On the other hand cost of equity will reduce as risk is shared by debt holders in large proportion.with further increase in proportion of debt rate of interest will be much higher than cost of equity due to higher risk.so, just increase in weight of debt will not reduce overall WACC but firm has to find appropriate mix of debt and equity to maintain WACC at optimum level.

What are the benefits and costs of using lot a debt ?

Answer :

Benefits :

A. Interest is tax-deductible.

B. Obligation is fixed in terms of interest and principal payments.

C. No control of equity holders are diluted.

Costs to debts :

A. Debt Covenants such as maintain minimum current ratio, audit of financial statements etc place restrictions.

B. Interest and principal must be paid irrespective of the entity's economic performance / position.

C. Increae in debt will have NEGATIVE impact on share prices.

Do you think it is necessary for a firm to adjust overall WACC according to the risk of each individual project ? Why ?

Answer : it is very much necessary for the firm to adjust overall WACC according to the risk of each individual project to avoid incorrect rejection of low - risk projects and incorrect acceptance of high - risks projects based on single WACC assement.

If firm insists that it will use only one WACC to evaluate all projects what will be the consequences in long run ?

Answer: by taking reference of above answer if firm insists on single WACC than in long run profitability will be negatively impacted as firm may reject low risk project and accept high risk project. Other implications will be increase in risk, under- utilisation of resources by rejecting low - risk projects. Reduction in residual income ( income remaining after all the necessary expenses and tax payment).