19 Apr The Allied Group is considering two investments. The first investment involves a packaging machine, which can be used to package garments for shipping orders to customers. The second possi

More about Weighted Average Cost of Capital (WACC)

Let’s now examine how a firm’s weighted average cost of capital (WACC) would be calculated.

Assume that a firm has the following capital structure:

· 30% debt

· 10% preferred equity

· 60% common equity

The company’s after tax cost of debt is 6%. The interest payments are business deductions from operating income, and therefore, tax deductible.

The cost of preferred stock (equity that pays a constant dividend) is 10%. The cost of common stock (equity that may pay a discretionary dividend determined by management) is 15%.

Assume that  the asset base is funded as follows:

· 30% by debt

· 10% by preferred equity

· 60% by common equity

Note that the sum of the component weights must equal 100%. The table shows that the firm’s WACC is 11.8%. In other words, on average, each dollar funding the asset base costs the firm about 12 cents. (We borrow a dollar, and the interest works out to $0.118, approximately $0.12, on an after-tax basis.)

Credit ratings can have a significant impact on the cost and availability of capital. Most small companies are privately held and cannot use the stock markets for raising money. (They’d have to be listed on an exchange and/or be available to the public to have opportunities to raise money in the stock market.)  

A common option is to raise money in markets through the sale of privately-placed bonds. In this case, the lack of debt rating hampers the company and relegates its corporate securities to low-grade or junk-bond status.

"Junk bonds" came under intense scrutiny in the late 1980s when firms such as Drexel Lambert led a wave of successful high-yield corporate bond issues. These contributed to the eruption of several corporate scandals that swept Wall Street at the time.

There is no question that the absence of a Moody's or Standard & Poor’s rating has an intense effect on the cost of debt and downgrades and upgrades. Ratings reflect management practices, and therefore risk, and are closely tied to the overall rates that enterprises must offer in the markets for their debentures.

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More about Weighted Average Cost of Capital (WACC)

Let’s now examine how a firm’s weighted average cost of capital (WACC) would be calculated.

Assume that a firm has the following capital structure:

· 30% debt

· 10% preferred equity

· 60% common equity

The company’s after tax cost of debt is 6%. The interest payments are business deductions from operating income, and therefore, tax deductible.

The cost of preferred stock (equity that pays a constant dividend) is 10%. The cost of common stock (equity that may pay a discretionary dividend determined by management) is 15%.

Assume that  the asset base is funded as follows:

· 30% by debt

· 10% by preferred equity

· 60% by common equity

Note that the sum of the component weights must equal 100%. The table shows that the firm’s WACC is 11.8%. In other words, on average, each dollar funding the asset base costs the firm about 12 cents. (We borrow a dollar, and the interest works out to $0.118, approximately $0.12, on an after-tax basis.)

Credit ratings can have a significant impact on the cost and availability of capital. Most small companies are privately held and cannot use the stock markets for raising money. (They’d have to be listed on an exchange and/or be available to the public to have opportunities to raise money in the stock market.)  

A common option is to raise money in markets through the sale of privately-placed bonds. In this case, the lack of debt rating hampers the company and relegates its corporate securities to low-grade or junk-bond status.

"Junk bonds" came under intense scrutiny in the late 1980s when firms such as Drexel Lambert led a wave of successful high-yield corporate bond issues. These contributed to the eruption of several corporate scandals that swept Wall Street at the time.

There is no question that the absence of a Moody's or Standard & Poor’s rating has an intense effect on the cost of debt and downgrades and upgrades. Ratings reflect management practices, and therefore risk, and are closely tied to the overall rates that enterprises must offer in the markets for their debentures.