Homework answers / question archive / According to Investopedia, WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the value

According to Investopedia, WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the value

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According to Investopedia, WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the value. The formula and components are as follows:

WACC=(VE?×Re)+(VD?×Rd×(1−Tc))

E=Market value of the firm’s equity

D=Market value of the firm’s debt

V=E+DRe=Cost of equity

Rd=Cost of debt

Tc=Corporate tax rate?

In unpacking the formula above it is clear how increased interest rates would affect each component:

Because the Federal Reserve (Fed) has just enormous influence over short-term interest rates and WACC through the fed funds rate, it impacts the interest rate at which a bank lends funds to another bank.

Changes in interest rates cause changes in the risk-free rate, or the theoretical rate of return for an investment that has no risk of financial loss. Increases and decreases in the federal funds rate affects the WACC because the risk-free rate is a key component in calculating the cost of capital. The interest rate paid by the firm equals the risk-free rate plus the default premium for the firm. When the Fed raises interest rates, the risk-free rate immediately increases. The higher cost of capital for the company might also increase the risk that it will default. That would raise the default premium and further increase the interest rate used for the WACC.

Changing interest rates also impact corporate tax rates, influence conditions in the economy and the markets, and create changes in market conditions. Changes in interest rates can increase volatility which in turn decreases the value of existing equity , making it less expensive for the firm to buy back shares. Higher corporate taxes increase WACC, while lower taxes reduce WACC.

Fernandez, as cited by Kim, lists a number of common mistake made when estimating the WACC

• Wrong rate
• Wrong beta
• Wrong market risk premium
• Incorrect det to equity ratio
• Use of discount rates lower than the risk free rate

These mistakes arise because according to the finance train, valuation is more art than science.

• A company’s capital structure can be very complicated making it more difficult to estimate the WACC.
• WACC is a forward looking measure and the calculations are based on expected returns, not on historical returns.
• Bonds are only listed with certain maturities such as 2, 5, 10 and 30 years. For any maturity in-between, the rate must be estimated.

 https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp

https://www.investopedia.com/ask/answers/070114/how-do-interest-rates-affect-weighted-average-cost-capital-wacc-calculation.asp

https://www.ajjacobson.us/capital-structure-2/four-mistakes-to-avoid.html

http://hanahkimhoang.blogspot.com/2012/02/weight-averages-cost-of-capital-errors.html