FACTORS

THAT
AFFECT THE
WACC
 Factors the Firm Cannot
Control

• Interest rates in the

economy
• General level of stock
prices
• Tax rates
Interest
rates
Ex:

Interest Cost of Cost of

rates debt capital
If interest in the economy rise, the
cost of debt increases
General level of stock prices
Ex:

Stock Cost of Cost of

price equity capital
If stock prices in general decline,
its cost of equity will rise.
Tax rates
Ex:

Tax rates Cost of Cost of

debt capital
When tax rates increases, cost
of debt decreases
FACTORS THE FIRM CAN CONTROL

• By changing its capital

structure
• By changing its dividend
payout ratio
• By altering its capital
budgeting decision
 Capital Structure Policy

As more debt is
issued, the cost
of debt
increases, and as
more equity is
issued, the cost
 Dividend Policy

As the payout
ratio of the
company
increases the
breakpoint
between lower-
cost internally
generated
 Capital Budgeting Policy

The company is
making investments
with similar degrees
of risk.
If a company
changes its
investment policy
relative to its risk,
 ADJUSTING THE COST OF CAPITAL
FOR RISK

Projects should be accepted

if and only if their
estimated returns exceed
their costs of capital.
Cost of capital is a “HURDLE RATE”

A project’s
expected rate
of return must
“jump the
hurdle” for it
to be accepted.
 Therefore, each projects hurdle rate
should reflect the risk of the project,
not the risk associated with the firm’s
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 H
0.50(7%) + 0.50(13%)
= 10%

Firm
A
SOME OTHER PROBLEMS WITH
COST OF CAPITAL ESTIMATES

• Depreciation-
generated funds
• Privately owned firms
• Measurement
problems
• Costs of capital for