Lecture 7 Quiz

WACC of a company is the rate of return that the company is required to earn on its assets. Because a company’s assets are financed by equity and debt, the required return on asset is the weighted average of the required return on equity and the required return on debt.

We calculate after-tax WACC because cash flows of a project are after-tax cash flows. We need after-tax cost of capital to discount after-tax cashflows.

We can use WACC of a multi-business company as the discount rate for investment projects in different businesses in this company. Majority of the projects in risky business will have positive NPV while majority of projects in low risk will have negative NPV, and that is exactly why we use WACC.

WACC can be used as the cost of capital to evaluate projects whose cashflows have the same risk as the cashflows of the company. Examples of these projects are business expansion projects.

EBIT of a company is shared among three parties: debt holders, equity holders and tax department. At 30% tax rate and $0 interest expense, a $100 EBIT will give $30 to tax department and $70 to equity holders. An increase of interest expense by $1 will reduce tax by $0.30 (to $29.70) and increase the payment to capital providers (debt and equity holders) by $0.30.

In presence of company tax, a company can increase the total return to capital providers (equity and debt holders) by increasing debt

Interest expense helps to reduce tax payment, which creates a benefit called ‘tax shield’. The net cost of an interest expense to the company is therefore not the interest expense, but the net of tax interest expense. At a 30% tax rate, the cost of having $1 interest expense to the company is only $0.70.

Tax has no effect on the net cost of interest expense to a company. If bond holders require a rate of return of 6% and the company borrows $100,000, then the net cost of using the debt capital is $6,000, irrespective of the tax rate.

The cost of debt for a bond is also known as ‘coupon rate’. It is the interest rate that bond issuers need to pay bond holders.

Acquiring a bond is similar to investing in a project, with the acquiring cost (market price of the bond) plays the role of the investment cost. Yield to maturity of the bond is the same as the internal rate of return of the project.

The cost of debt for a bond is also called ‘yield to maturity’ or ‘bond yield’.

Yield to maturity of a bond is the discount rate at which the cash flows provided by the bond has a total present value equal to the market price of the bond.

Floatation cost is the transaction costs incurred when a company raises capital. It includes the cost of preparing documents, advertising and determining the price for the share or bond issue.

If a company uses internal equity and debt to finance projects and do not issue new equity, the floatation cost is zero.

Floatation cost is an incremental cashflow to a project. This is because if the project is not invested, there is no need to raise capital and the floatation cost would not be incurred.

Floatation cost is incorporated through the investment cost of the project. If the investment cost required by a project is $1 million and the floatation cost is 5%, then the total investment cost that includes floatation cost would be 1/(1-5%) = $1.052 million.

The cost of capital used to discount the cash flows of a project should reflect the riskiness of the cash flows of the project. If WACC of the company is not available, we can use the market interest rate given by the yield of bonds issued by the government.

Cost of debt can be estimated by the weighted average cost of all debt issues by the company. It can also be estimated by the cost of debt of another company that has a similar default risk or credit ratings.

To evaluate a project that is not in the business of a company, we should not use the WACC of the company. We should use the WACC of companies that operate in the business operated by the project.

Cost of equity can be estimated using either dividend growth model or CAPM. The former applies only to mature and dividend paying firms, while the latter can apply to all listed firms.