fin ch 10
Federal Reserve tightens credit
cost of debt: + cost of equity: + WACC: +
Investors become more risk-averse.
cost of debt: + cost of equity: + WACC: +
The firm expands into a risky new area.
cost of debt: + cost of equity: + WACC: +
The firm is an electric utility with a large investment in nuclear plants. Several states are considering a ban on nuclear power generation.
cost of debt: + cost of equity: + WACC: +
Suppose a firms WACC is 10%. Should this WACC be used to evaluate all projects, even if they vary in risk
In general, failing to adjust for differences in risk would lead the firm to accept too many risky projects and reject too many safe ones. Over time, the firm would become more risky, its WACC would increase, and shareholder value would suffer. The cost of capital for average-risk projects would be the firm's cost of capital, 10%. A somewhat higher cost would be used for more risky projects, and a lower cost would be used for less risky ones. For example, we might use 12% for more risky projects and 9% for less risky projects. These choices are arbitrary.
The WAcc is a weighted average of the costs of debt, preferred stck, and common equit. would the WAcc be different if the equity coming for the coming year came solely in the form of retained earnings vs some equity from the sale of new common stock? would calculated WACC depend in any way on the size of the cpital budget ? How might dividend policy affect the WACC?
The cost of retained earnings is lower than the cost of new common equity; therefore, if new common stock had to be issued then the firm's WACC would increase. The calculated WACC does depend on the size of the capital budget. A firm calculates its retained earnings breakpoint (and any other capital breakpoints for additional debt and preferred). This R/E breakpoint represents the amount of capital raised beyond which new common stock must be issued. Thus, a capital budget smaller than this breakpoint would use the lower-cost retained earnings and thus a lower WACC. A capital budget greater than this breakpoint would use the higher cost of new equity and thus a higher WACC. Dividend policy has a significant impact on the WACC. The R/E breakpoint is calculated as the addition to retained earnings divided by the equity fraction. The higher the firm's dividend payout, the smaller the addition to retained earnings and the lower the R/E breakpoint. (That is, the firm's WACC will increase at a smaller capital budget.)
how should the capital structure weights used to calculate WACC be determined
The target proportions of debt, preferred stock, and common equity, along with the costs of those components, are used to calculate the firm's weighted average cost of capital, WACC.
firm uses more debt; debt ratio increases
cost of debt: + cost of equity: + WACC: indeterminate
corporate tax rate is lowered
cost of debt: + cost of equity: intdeterminate WACC: +
The firm merges with another firm whose earnings are countercyclical both to those of the first firm and to the stock market.
cost of debt: - cost of equity: - WACC: -
The stock market falls drastically, and the firm's stock price falls along with the rest.
cost of debt: indeterminate cost of equity: + WACC: +
The dividend payout ratio is increased
cost of debt: indeterminate cost of equity: indeterminate WACC: indeterminate
The firm doubles the amount of capital it raises during the year.
cost of debt: indeterminate or + cost of equity: indeterminate or + WACC: indeterminate or +
% of debt after tax cost of debt % of preferred stock cost of preferred stock % of common equity cost of common equity OR cost of equity from new stock w/ flotation
wd rd(1-T) wp rp= Dp/Pp wc rs=rrf+(RPM)b rs=rrf+RP rs=D1/P0 re= D1/P0(1-F) +g
