Question

The WACC formula implies that debt is “cheaper” than equity, that a firm with more debt could use lower discount rate. Does this make sense?  Explain briefly

Answer 1

Answer :- The statement given in question (about the WACC formula) does not make any sense i.e., incorrect one.

Explanation :- Weighted average cost of capital (WACC) can be defined as the average of the costs of each source of finance (debt / common stock / preferred stock) employed by the company properly weighted by the proportion they held in the capital structure of the company. The WACC formula is :-

WACC = Weight of common stock * Cost of common stock + Weight of preferred stock * Cost of preferred stock + Weight of debt * Cost of debt (after-tax).

It is not always that a firm employing more debt (in its capital structure) will have lower discount rate i.e., lower WACC due to the following reasons:-

i). The capital structure of firm consist of common stock, preferred stock or retained earnings etc.

ii). The cost of debt (interest on borrowed funds even after tax deductibility) is very high as compared to the cost of common stock / cost of preferred stock.