At very high levels of gearing, other costs come into play and the WACC can be shown to increase again — looking rather like the conventional theory.
Therefore, if a new project consisting of more business activities of the same type is to be funded so as to maintain the present gearing ratio, the current WACC is the appropriate discount rate to use. The condition that gearing is constant does not have to mean that upon every issue of capital both debt and equity also have to be issued.
That would be very expensive in terms of transaction costs. What it means is that over the long term the gearing ratio will not change. Therefore, this year, it might issue equity, the next debt and so on, so that the gearing and WACC hover around a constant position.
Different activities will have different risk characteristics and hence any business carrying on those activities will have a different beta factor.
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- Weighted Average Cost of Capital | Formula | Calculate WACC?
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The new funds being put into the new project are subject to the risk inherent in that project, and so should be discounted at a rate which reflects that risk. The formula:. Note that we are doing something quite radical here: CAPM is allowing us to calculate a risk adjusted return on equity, tailor-made to fit the characteristics of the project being funded.
All projects consist of capital being supplied, being invested and therefore being subject to risk, but the risk is determined by the nature of the project, not the company undertaking the project.
The existing return on equity of the company that happens to be the vehicle for the project has become irrelevant. We can extend this argument as follows. So we can calculate the cost of equity component which reflects project risk by using a beta value appropriate to that risk. The final steps are to adjust the cost of equity to reflect the gearing and then to calculate the appropriate discount rate, the WACC. No matter how reasonable the conventional theory seems, its big drawback is that it makes no quantitative predictions.
However, the Modigliani and Miller theory does make quantitative predictions, and when combined with CAPM theory it allows the beta factor to be adjusted so that it takes into account not only business risk but also financial gearing risk. The formula you need is provided in the exam formula sheet:. The asset beta is the beta a measure of risk which arises from the assets and the business the company is engaged in.
Cost of Capital
No heed is paid to the gearing. The equity beta is the beta which is relevant to the equity shareholders. If there is debt, the asset beta will always be less than the equity beta because the latter contains an additional component to account for gearing risk. The formula is extremely useful as it allows us to predict the beta, and hence the cost of equity, for any level of gearing.
Once you have the cost of equity, it is a straightforward process to calculate the WACC and hence discount the project. Emway Co is a company engaged in road building. Its cost of equity is Note: this figure is quite high in the current economic situation and is used for illustration purposes. Currently, in a real situation, the cost of equity would be lower. The company is worried about the recession and is considering diversifying into supermarkets. It has investigated listed supermarkets and found one, Foodoo Co, which quite closely matches its plans.
Foodoo has a beta of 0. Emway plans that its new venture would be financed with a market value of equity to market value of debt ratio of We have information supplied about a company in the right business but with the wrong gearing for our purposes. To adjust for the gearing we plan to have, we must always go through a theoretical ungeared company in the same business. Again the beta supplied to us will be the beta measured in the market, so it will be an equity geared beta.
Were Foodoo to be ungeared, its asset beta would be given by:. This asset beta ungeared beta can now be adjusted to reflect the gearing ratio planned in the new venture:.
Check that this makes sense. Foodoo has a gearing ratio of , equity to debt, a current beta of 0. Were Foodoo ungeared, its beta would be 0. Emway is planning a supermarket with a gearing ratio of Note that while Financial Management does not require students to undertake calculations of a project-specific WACC, they are required to understand it from a theoretical perspective.
So how to measure the cost of equity? We need to look at how investors buy stocks. They purchase stocks with the expectation of a return on their investment based on the level of risk. This expectation establishes the required rate of return that the company must pay its investors or the investors will most likely sell their shares and invest in another company.
If too many investors sell their shares, the stock price could fall and decrease the value of the company. I told you this was somewhat confusing. Think of it this way.
The WACC | Boundless Finance
Compared with the cost of equity, the cost of debt, represented by Rd in the equation, is fairly simple to calculate. We simply use the market interest rate or the actual interest rate that the company is currently paying on its obligations. Keep in mind, that interest expenses have additional tax implications.
Interest is typically deductible, so we also take into account the amount of tax savings the company will be able to take advantage of by making its interest payments, represented in our equation Rd 1 — Tc. To put it simply, the weighted average cost of capital formula helps management evaluate whether the company should finance the purchase of new assets with debt or equity by comparing the cost of both options.
Financing new purchases with debt or equity can make a big impact on the profitability of a company and the overall stock price. Executives and the board of directors use weighted average to judge whether a merger is appropriate or not. Investors and creditors, on the other hand, use WACC to evaluate whether the company is worth investing in or loaning money to. As the weighted average cost of capital increases, the company is less likely to create value and investors and creditors tend to look for other opportunities. You can think of this as a risk measurement.
Investors use a WACC calculator to compute the minimum acceptable rate of return. An investor would view this as the company generating 10 cents of value for every dollar invested. This cent value can be distributed to shareholders or used to pay off debt. This means the company is losing 5 cents on every dollar it invests because its costs are higher than its returns.