FACTORS THAT AFFECT THE WACC

FACTORS THAT AFFECT THE WACC

Factors the Firm Cannot ControlInterest rates in the economyGeneral level of stock pricesTax rates

Interest ratesInterest ratesCost of debtCost of capitalIf interest in the economy rise, the cost of debt increasesEx:Debt FinancingThe connection between interest rates and the cost of debt financing is easy to see. When you borrow money, you have to pay interest to the lender. That's the price you pay for using the lender's money. When interest rates are rising, you'll pay more in interest, and your cost of capital rises. When interest rates fall, you'll pay less for debt financing. One mitigating factor with debt financing is the fact that the interest you pay is a tax-deductible business expense, so every $1 you pay in interest can offset $1 in revenue, reducing your taxable profit.

ConclusionAs interest rates are a major factor of the income you can earn by lending money, of bond pricing and of the amount you will have to pay to borrow money, it is important that you understand how prevailing interest rates change: primarily by the forces of supply and demand, which are also affected by inflation and monetary policy. Of course, when you are deciding whether to invest in a debt security, it is important to understand how its characteristics determine what kind of interest rate you can receive.

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General level of stock pricesIf stock prices in general decline, its cost of equity will rise.Stock priceCost of equityCost of capitalEx:

Tax ratesTax ratesCost of debtCost of capitalEx:When tax rates increases, cost of debt decreases

FACTORS THE FIRM CAN CONTROLBy changing its capital structureBy changing its dividend payout ratioBy altering its capital budgeting decision rules

Capital Structure Policy

Other things held constant, an increase in the target debt ratio tends to lower the WACC (and vice versa if the debt ratio is lowered)Other things not likely to held constant, an increase in the use of debt will increase riskiness of both debt and the equity and raise WACC.As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.7

Capital Structure Policy

As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increasesAs we have been discussing above, a firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.8

Dividend PolicyAffects the amount of retained earnings available to the firm and thus the need to sell new stock and incur flotation costs.The higher the dividend payout ratio, the higher the cost of equity, and therefore the higher the WACC.

Dividend Policy As the payout ratio of the company increases the breakpoint between lower-cost internally generated equity and newly issued equity is lowered.

Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed10

Capital Budgeting PolicyInvesting in an entirely new and risky line of business, its component costs of debt and equity will increase and thus its WACC.

When we estimate the firms cost of capital, we use as the starting point the required rates of return on its outstanding stock and bonds.11

Capital Budgeting PolicyIf a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.

The company is making investments with similar degrees of risk.It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.12

ADJUSTING THE COST OF CAPITALFOR RISKProjects should be accepted if and only if their estimated returns exceed their costs of capital.

Cost of capital is a HURDLE RATE

A projects expected rate of return must jump the hurdle for it to be accepted.

Investors require higher returns for riskier investments.Companies that are raising capital to take on risky projects will have higher costs of capital than companies that are investing in safer projects.

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Therefore, each projects hurdle rate should reflect the risk of the project, not the risk associated with the firms average project as reflected in the composite WACC.But if a project has an especially high or low risk, the WACC will be adjusted to account for the risk differential.

L H0.50(7%) + 0.50(13%) = 10% Firm A

SOME OTHER PROBLEMS WITH COST OF CAPITAL ESTIMATESDepreciation-generated fundsPrivately owned firmsMeasurement problemsCosts of capital for projects of differing risksCapital structure weights