Question

Answer the following conceptual questions related to the WACC (when valuing a firm)

a. How is the weighted average cost of capital calculated? Write out the equation.

b. Why is the weighted average cost of capital the appropriate rate to discount the FCFs of a firm?

c. What is a target capital structure?

d. Why is the after-tax cost of debt, rather than its before-tax required rate of return, used to calculate the weighted average cost of capital?

e. Is the relevant cost of debt, when calculating the WACC, the coupon rate on existing debt or the yield to maturity on existing debt? Why?

f. What are the two primary sources of equity capital? Explain why there is a cost to using reinvested (retained) earnings; that is, why aren’t reinvested earnings a free source of capital?

Answer 1

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

(b) The discount rate should reflect (among others) the opportunity cost, i.e. what are the alternative uses for this cash. The cost of capital is the company's required return. The company's lenders and owners don't extend financing for free; they want to be paid for delaying their own consumption and assuming investment risk. The cost of capital helps establish a benchmark return that the company must achieve to satisfy its debt and equity investors.

Since all the variables in the formula for WACC refer to the firm as a whole, as a result the formula gives the right discount rate only for projects that are just like the firm undertaking them. The formula works for the "average" project. In situations where the new project is considerably more or less risky than the company's normal operation, it may be best to add in a risk premium in case the cost of capital is undervalued or the project does not generate as much cash flow as expected.

(c) Target capital structure describes the mix of debt, preferred stock and common equity which is expected to optimize a company's stock price. Hence, the company is always striving to obtain this target capital structure.

(d) The firm uses after tax cost of debt so as to capture the value of interest tax shields.

The company saves on its tax liability by having debt in its capital structure, and cost of debt is adjusted by multiplying (1-Tc) to reflect this.

(e) Cost of debt is the required rate of return on debt capital of a company. Yield to maturity (YTM) equals the internal rate of return of the debt, i.e. it is the discount rate that causes the debt cash flows (i.e. coupon and principal payments) to equal the market price of the debt.

Cost of debt essentially reflects the return desired by its bondholders for lending to the firm. If the bondholders were to withdraw this money and invest in another debt instrument with same level of risk (rating), YTM will be the return they will earn.

(F) 1. Retained earnings of the business

2. Issuing new shares and raising equity capital from the market

The firm owes the profits from the business to its shareholders. Therefore, by reinvesting the firm's profits into the business, the firm essentially is preventing company's shareholders to invest it elsewhere. Hence, there is an opportunity cost involved and the firm is expected to generate returns greater than or equal to the cost of equity from retained earnings for its shareholders.