Question

What are the most prominent factors that determine a firm’s weighted average cost of capital?

Answer 1

1) The interest rate environment - If the central bank policies are hawkish in nature (in favour of higher interest rates), the WACC will be higher. Since, the returns expected by both debt and equity investors will be higher due to higher carry cost. On the other hand, if the interest rates are lower (dovish stance by central banks), the WACC will be lower

2) Riskiness of the industry & company - Industries which are more cyclical in nature or if experiencing economic downturns, the returns expected by the investors will be higher. For example, stable industries like FMCG, Pharma, Banks etc. have lower WACC as compared to riskier industries like aviation, metals & mining, textiles etc.

3) Capital structure - Equity has the highest cost of capital, while debt is the cheapest. Companies which have more equity as their sources of fund will have a higher WACC.

4) Taxation - Higher taxes mean higher return expected by the investors. Therefore, industries/companies which are taxed higher will have higher WACC to compensate for higher taxation

5) Dividend policy - If a company has a policy of lower dividend distribution, it means that it is retaining its capital at the cost of equity (which has higher cost) - thus, increasing the amount of equity in the capital structure. Therefore, the return expected by the investors will be higher.