The Cost of Capital (Chapter 15)

OVU-ADVANCE Managerial Finance D.B. Hamm, rev. Jan 2006

Final notes on WACC

WACC should be based on market rates and valuation, not on book values of debt or equity. Book values may not reflect the current marketplace WACC will reflect what a firm needs to earn on a new investment. But the new investment should also reflect a risk level similar to the firms Beta used to calculate the firms RE.
In the case of ABC Co., the relatively low WACC of 8.81% reflects ABCs =.74. A riskier investment should reflect a higher interest rate.

Equity vs Debt Financing (1)

Since the WACC is the weighted average of cost of equity + cost of debt, we can vary the WACC by changing the mix of debt + equity
If cost of debt < cost of equity, we can reduce WACC by increasing the % of debt in the mix and vice versa

The value of the firm (its earnings potential) is maximized when its WACC is minimized.
A firm with a lower cost of capital can more easily return profits to its owners

Debt vs Equity Financing (2):

The optimal, or target capital structure is the structure with the lowest possible WACC The Interest Tax Shield (deductibility of corp. interest) is critical here, because it effectively lowers the cost of debt. Therefore for many firms, the use of financial leverage (debt financing) can lower WACC and increase profitability

Debt vs. Equity Financing (3):

Warning: choice between debt & equity can not be based on interest rates, etc. alone. Risk must be considered as well Systematic risk (see ch. 13) consists of two factors which must be considered
Business riskrisk inherent in firms operations Financial riskrisk inherent in using debt financing

Remember debt is a multiplier:

it can multiply returns if returns > cost of debt; but it can also multiply losses, or returns < cost of debt.

Financial Leverage Considerations:

If profits are down, dividends (the key cost of equity financing) can often be deferred. Interest (cost of debt) must always be paid for a firm to remain solvent Financial distress costs: costs incurred with going bankrupt or costs that must be paid to avoid bankruptcy According to the static theory of capital structure, gains from the tax shield are offset by the greater potential of financial distress costs.

Optimal Capital Structure:

Optimal capital structure is achieved by finding the point at which the tax benefit of an extra dollar of debt = potential cost of financial distress. This is the point of:
Optimal amount of debt Maximum value of the firm Optimal debt to equity ratio Minimal cost of WACC

This will obviously vary from firm to firm and takes some effort to evaluate. No single equation can guarantee profitability or even survival

Critical considerations:

Firms with greater risk of financial distress must borrow less The greater volatility in EBIT, the less a firm should borrow (magnify risk of losses) Costs of financial distress can be minimized the more easily firm assets can be liquidated to cover obligations A firm with more liquid assets may therefore have less financial risk in borrowing A firm with more proprietary assets (unique to the firm, hard to liquidate) should minimize borrowing