Question

QUESTION THREE [20]

Critically discuss the differences in opinion as to how weighted average cost of capital (WACC) is affected by the differing levels of equity and debt.

Answer 1

WACC is Weigted Average Cost of Capital.

This cost of capital consist of cost of debt and cost of equity.

Hence overall cost of capital depend on weightage cost of equity and weightage cost of debt.

One of the benfit that debt provides is tax saving which results in lower wacc.

WACC = Wd*Rd*(1- tax) + We*Re..............(1)

Wd is weight of debt

We is weight of debt

Rd is Cost of debt

Re is Cost of equity

Wd = Tota Debt / (Total Debt + Total Equity)

We = Total Equity / (Total Debt + Total Equity)

WACC = Wd*Rd*(1- tax) + We*Re

Hence, By varying amount of debt and amount of equity, we can vary wacc.

Consider a situation:

Rd = 5%

Re = 8%

Tax = 40%

Debt = 100

Equity = 100

Wd = 0.5

We = 0.5

WACC = 0.5*8 + 0.5*5*(1-0.4) = 5.5 %

Let say equity is increase by 50

Equity = 150

Debt = 100

Wd = 0.4

We = 0.6

WACC = 0.4*5*(1-0.4) + 0.6*8 = 6%  

Hence you can see how wacc is varying by changing debt and equity.