Module 7 Flashcards
Weighted-Average Cost of Capital (WACC)
The weighted-average after-tax cost of the capital used by a firm, with weights set equal to the relative percentage of each type of capital used
Component Costs
The individual costs of each type of capital-bonds, preferred stock, and common stock
Tax Cut and Jobs Act (TCJA) of 2017
had significant direct and indirect effects on the calculation of the WACC, which make the calculation a little more complicated than it was before. Also placed constraints on when firms can deduct those interest payments.
Taxable Income
(2018-2021) Income with allowable deductions for depreciation, amortization, and depletion added back in (i.e., EBITDA). (2022-onward) adjustable taxable income will be set equal to EBIT.
Unconstrained Scenario
the vast majority of healthy, publicly traded firms, we think that interest on all their debt will be fully tax deductible
Constrained Scenario
For firms that have so much debt that at least 30 percent of their EBITDA or EBIT (as appropriate) is already claimed by existing debt issues for the foreseeable future, the likelihood of being able to take advantage of the interest tax shield on a new debt issue for such firms is either so low or so far away in the future that it might as well not even exist.
Uncertain Scenarios
For firms that more-or-less fall in the middle of the other two scenarios, being unable to immediately take full advantage of the tax interest shields during the period when the interest payments are made, but also being expected to be able to use those interest tax shields at some near-term time in the future, means that the impact of the interest tax shields will fall somewhere in the middle between the first two scenarios.
The most difficult scenario to model
The third scenario, uncertain
WACC (unconstrained)
= Percentage of equity x Cost of equity + Percentage of preferred stock x Cost of preferred stock + Percentage of debt x After-tax cost of debt
= (E/ E+P+D) x (i of e) + (P/E+P+D) x (i of p) + (D/E+P+D) x (i of d) x (1-T of c)
WACC (constrained)
= Percentage of equity x Cost of equity + Percentage of preferred stock x Cost of preferred stock + Percentage of debt x After-tax cost of debt
= (E/ E+P+D) x (i of e) + (P/E+P+D) x (i of p) + (D/E+P+D) x (i of d)
The variables in WACC equations (unconstrained and constrained)
E = Market Value of equity used in financing the relevant project or firm
P = Market Value of preferred stock used
D = Market Value of debt used
(E/E+P+D) = Percentage of financing that is equity
(P/E+P+D) = Percentage of financing that is preferred stock
(D/E+P+D) = Percentage of financing that is debt
i of e = Cost of equity
i of p = Cost of preferred stock
i of d = Before-tax cost of debt
T of c = The marginal corporate tax rate
Why do we use Market Values rather than Book Values?
Market values reflect investors’ assessment of what they would be willing to pay for the various types of securities, while book values would reflect what was paid for such securities at varying times in the past. Since we are interested in coming up with the cost of capital for new investments in the firm or its projects, using market values here makes more sense
Calculating the Component Cost of Equity (i of e)
i of e = (R of f) + B( (R of m) - (R of f) )
B is beta
Calculating the Component Cost of Equity (i of e) assuming a constant-growth stock
i of e = (D1/P0) + g
Calculating the Component Cost of Preferred Stock (i of p)
i of p = D1/P0
