WACC and Capital Structure

Question 1

What is the formula for WACC?

Answer 1

WACC = we x ke + wd x kd x (1-t)

Question 2

How does WACC influence investment decisions?

Answer 2

WACC serves as a hurdle rate in capital budgeting. Projects with a return greater than WACC should be accepted as they generate value.

Question 3

What does Modigliani and Miller Theorem 1 state about capital structure?

Answer 3

MM1 states that in a perfect market (no taxes, bankruptcy costs), the value of a firm is independent of its capital structure

Question 4

What additional factor does MM2 introduce, and what are its implications?

Answer 4

MM2 introduces taxes, suggesting that leverage increases firm value due to the interest tax shield, making debt financing more attractive.

Question 5

What does the Trade-Off theory suggest about capital structure?

Answer 5

It suggests that firms balance the tax benefits of additional debt against the cost of potential financial distress.

Question 6

How do you calculate the value of a firm using WACC?

Answer 6

Firm value can be estimated using the formula:
Value = Net Cash Flow/ WACC
Assuming perpetual cash flows

Question 7

What does the Pecking Order Theory suggest?

Answer 7

Firms prefer to finance projects in the following order:
- Internal funds
- Thru debt
- Thru issuing equity (last resort)

Question 8

Explain the components of the WACC formula?

Answer 8

We = Weighted equity
Wd = Weighted debt
ke = Cost of equity
kd = Cost of Debt
T = Tax rate