Question

Does having a default free bond mean that WACC underestimates the company's risk?

Answer 1

Explain the terms

A. Default free bonds - Bonds in which there is no risk of default like in us treasury bills used by us government. in default free bonds the issuer promises to pay interest whenever it's due and principal at time of maturity without any default.

B. WACC - Weighted Average Cost of capital. As name suggests it measures the cost of capital by taking weighted average of proportion of different form of capital such as equity stocks, preference stocks, bonds etc with respect to individual cost of the set of equity stocks, bonds etc. It acts basis for measures cost of procurement of the capital.

ANSWER -

The answer to above questions deprnds companies situation. Any set of the bond is considered DEFAULT FREE bond after considering the payment cycle or the report credit rating independent agency. If the particular company's claim is supported by above documents like credit rating report. Then the practice adopted by the company to reduce the cost of bonds by not taking into account default risk as result WACC will be lower this is not termed as underestimation of risk.

But if the company without any evidence claim the bond as default free bond and reduce the WACC to obtain finance at low cost as further finance is highly dependent on the WACC. This type of practice can be considered as Underestimation of risk by the company to borrow at lower cost in future.

Additional points -

Even in case of default free bonds there will be possibilities of interest rate risk i.e change in the rate of interest due to inflation or any other reasons. default risk free bonds don't mean they have no risk what so ever.

Conclusion-

So, just having default free bonds don't imply the underestimation of risk while calculating WACC .If there is proper classification of bonds as default free which is backed by necessary documents it is generally accepted practice by the company.