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The Cost of Capital (Chapter 15)

OVU-ADVANCE

Managerial FinanceD.B. Hamm, rev. Jan 2006

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Final notes on WACC

WACC should be based on market rates andvaluation, not on book values of debt orequity. Book values may not reflect thecurrent marketplace

WACC will reflect what a firm needs to earnon a new investment. But the new investmentshould also reflect a risk level similar to thefirms Beta used to calculate the firms RE.

In the case of ABC Co., the relatively low WACCof 8.81% reflects ABCs =.74. A riskierinvestment should reflect a higher interest rate.

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Equity vs Debt Financing (1)

Since the WACC is the weighted average ofcost of equity + cost of debt, we can vary theWACC 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 andvice 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

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Debt vs Equity Financing (2):

The optimal, or target capital structure is thestructure with the lowest possible WACC

The Interest Tax Shield(deductibility of corp.

interest) is critical here, because it effectivelylowers the cost of debt.

Therefore for many firms, the use of financialleverage (debt financing) can lower WACC

and increase profitability

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Debt vs. Equity Financing (3):

Warning: choice between debt & equity cannot be based on interest rates, etc. alone.Risk must be considered as well

Systematic risk (see ch. 13) consists of twofactors which must be considered Business riskrisk inherent in firms operations

Financial riskrisk inherent in using debtfinancing

Remember debt is a multiplier: it can multiply returns if returns > cost of debt; but

it can also multiply losses, or returns < cost ofdebt.

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Financial Leverage Considerations:

If profits are down, dividends (the key cost ofequity financing) can often be deferred.

Interest (cost of debt) must always be paid fora firm to remain solvent

Financial distress costs:costs incurred withgoing bankrupt or costs that must be paid toavoid bankruptcy

According to the static theory of capitalstructure, gains from the tax shield are offsetby the greater potential of financial distresscosts.

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Optimal Capital Structure:

Optimal capital structure is achieved byfinding the point at which the tax benefit of anextra dollar of debt = potential cost offinancial 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 andtakes some effort to evaluate. No singleequation can guarantee profitability or evensurvival

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Critical considerations:

Firms with greater risk of financial distress mustborrow less

The greater volatility in EBIT, the less a firm shouldborrow (magnify risk of losses)

Costs of financial distress can be minimized the moreeasily firm assets can be liquidated to coverobligations

A firm with more liquid assets may therefore haveless financial risk in borrowing

A firm with more proprietary assets (unique to thefirm, hard to liquidate) should minimize borrowing