Factors That Affect The Wacc 49132k

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 rates

Cost of debt

Cost of capital

If interest in the economy rise, the cost of debt increases

General level of stock prices Ex:

Stock price

Cost of equity

Cost of capital

If stock prices in general decline, its cost of equity will rise.

Tax rates Ex:

Tax rates

Cost of debt

Cost of 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 lowercost 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 for the risk differential.

L H 0.50(7%) + 0.50(13%) = 10%

Firm A

SOME OTHER PROBLEMS WITH COST OF CAPITAL ESTIMATES

• Depreciationgenerated funds • Privately owned firms • Measurement problems • Costs of capital for