Question

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect each component of the weighted average cost of capital (WACC). What mistakes are commonly made when estimating the WACC, and how do these mistakes arise?

Answer 1

If the Federal Reserve Bank decides to raise the interest rates, the cost of debt will be higher because the commercial banks would pass on the higher interest rates to consumers or companies. Hence, if the cost of debt becomes more expensive, then the corporations would be looking to raise more money through preferred shares. When a company braises money through preferred shares, the amount of weights changes. Hence, each and every component of the weighted average cost of capital is affected

Some of the common mistakes that arise while calculating weighted average cost of capital are as follows. The coupon rate of the existing debt is taken into consideration while calculating the weighted average cost of capital which is erroneous as it should be based on the coupon rate of the debt based on what the corporation would have paid if it were to issue new debt today.

The book value of debt, preferred stock and equity stock is taken into consideration while the market value of debt, preferred stock and equity should be taken into consideration while calculating the weighted average cost of capital.