Question

1. The weighted average cost of capital (WACC) is calculated as the weighted average of cost of component capital, including debt, preferred stock and common equity. In general, debt is less expensive than equity because it is less risky to the investors. Some managers may intend to increase the usage of debt, therefore increase the weight on debt (Wd). Do you think by increasing the weight on debt (Wj) will reduce the WACC infinitely? What are the benefits and costs of using a lot of debt? 2. Do you think it is necessary for a firm to adjust its overall WACC according to the risk of each individual project? Why? If a firm insists that it will use only one WACC to evaluate all its projects, what would be the consequence in the long term?

Answer 1

Answer 1:

WACC is calculated as weighted average of component capital including debt, preferred stock and common equity.

Debt is less expensive and interest on debt is tax deductible. As such increase in debt proportion in capital structure will reduce overall WACC upto a point where optimal capital structure is reached. Beyond that if debt is increased WACC will increase since higher leverage means higher risk and bankers/investors will demand higher rate of interest. Cost of equity will also increase.

Hence, using a lot of debt is not beneficial, debt as per optimal capital structure is beneficial. Such leverage will minimize WACC and maximize share value.

Answer 2:

In case of multi product/business line Company, project may belong to different business/product lines. Each business line has different beta.

In such a case it is better to adjust WACC based on beta of such business line and such adjusted WACC is used to evaluate the project of that business line.

Higher beta may lead to a higher WACC.

In case one single WACC is used to evaluate all its projects across different business lines, consequences will be:

(i) The company will end up implementing projects which may actually erode its value.

(ii) The company will reject projects that it should have accepted and which would have added value to its shareholders.

Such policy of using one single WACC will result in erroneous decisions of both rejecting good projects and accepting bad projects which may prove disastrous to the company.