Scribd
Upload
53 views18 pages

Wacc Approach To Capital Structure

The document discusses optimal capital structure and the weighted average cost of capital (WACC) approach. It explains that an optimal capital structure balances debt and equity to maximize firm value while minimizing costs. WACC calculates the weighted average of each capital component's cost to determine a firm's overall cost of capital. While WACC provides a simple hurdle rate for projects, its assumptions of constant capital structure and tax rates can be unrealistic.

Uploaded by

Ankit Neupane
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
53 views18 pages

Wacc Approach To Capital Structure

The document discusses optimal capital structure and the weighted average cost of capital (WACC) approach. It explains that an optimal capital structure balances debt and equity to maximize firm value while minimizing costs. WACC calculates the weighted average of each capital component's cost to determine a firm's overall cost of capital. While WACC provides a simple hurdle rate for projects, its assumptions of constant capital structure and tax rates can be unrealistic.

Uploaded by

Ankit Neupane
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 18

WACC APPROACH TO CAPITAL

STRUCTURE

Presented By:
Ankit Neupane Presented To:
Rabin khasu magar
Dhan bahadur
pun
Optimal capital structure
• An optimal capital structure is that capital structure or
combination of debt, preferred stock and equity that
maximizes a company market value while minimizing its cost
of capital.
• If debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed as
a deductible expenses in computation of tax.
• According to economists Modigliani and Miller, in the absence
of taxes, bankruptcy costs, agency cost and asymmetric
information, and in efficient market the value of firm is
unaffected by its capital structure.
The Basics of Optimal capital structure
• Optimal capital structure is estimated by calculating the mix of
debt and equity which minimizes the weighted average cost of
capital and maximizes market value.
• The lower the cost of capital, the greater the present value of
the firm’s future cash flow discounted by WACC. Thus, the
chief goal of any corporate finance department should be to
find the optimal capital structure that will result in lowest
WACC and the maximum value of the company.
Limitations of optimal capital structure

• The optimal debt-equity mix is difficult to


ascertain in true sense.
• It is very difficult to find an optimal capital
structure as the extent to which the market
value of an equity share will fall due to
increase in risk of high debt content in capital
structure, is very difficult to measure.
Limitations of optimal capital structure

There is no any fundamental rule to use debt


equity ratio as a guidance to achieve optimal
capital structure. The blend of debt and equity
varies according to the industries involved, line
of business, and a firm’s stage of development
and also vary over time due to external changes
in interest rates and regulatory environment.
WACC
• The weighted average cost of capital (WACC) is a
calculation of a firm's cost of capital in which each
category of capital is proportionately weighted. All
sources of capital, including common stock, preferred
stock, bonds, and any other long-term debt, are
included in a WACC calculation.
• A firm’s WACC increases as the beta and rate of
return on equity increase because an increase in
WACC denotes a decrease in valuation and an
increase in risk.
Assumptions of WACC
•The WACC can very well work as a hurdle rate in evaluating the new
projects provided the following two underlying assumptions are true
for those new projects.

•WACC is the average of the costs of these types of financing, each of


which is weighted by its proportionate use in a given situation. By
taking a weighted average in this way, we can determine how much
interest a company owes for each dollar it finances.
•A firm's WACC is the overall required return for a firm. Because of
this, company directors will often use WACC internally in order to
make decisions, like determining the economic feasibility of mergers
and other expansionary opportunities. WACC is the discount rate that
should be used for cash flows with the risk that is similar to that of the
overall firm.
Advantages of WACC
The biggest advantage of using WACC as a hurdle rate to evaluate the new
projects is its simplicity. The calculation does not involve too much of
complication. The manager just needs to apply weights of each source
finances with its cost and aggregate the result.

• Single Hurdle Rate for All Projects


One single hurdle rate for all projects saves a lot of time of the managers in
an evaluation of the new projects. If the projects are of same risk profile and
there is no change in the proposed capital structure, the current WACC can be
applied and effectively used.
• Prompt Decisions Making
Since the single rate is used for all new projects, the decisions can arrive at
a faster pace and the new opportunity can be grabbed and taken benefit of.
Disadvantages of WACC
• Difficulty in maintaining capital structure
• The impractical assumptions of ‘No Change in Capital
Structure’ has rare possibilities of prevailing all the time. It
suggests the same capital structure for new projects. There
are two possibilities for funding the project in this way.
• First is to fund it with the retained earnings. In this case, it
would be reasonably correct to assume that the new project
is funded with same capital structure. The limitation here
is of availability of free cash with the company.
Disadvantages of WACC
• Second possibility is raising fund in the same capital
mix. It is not impossible to do that but at the same
time getting funds at our own terms is not easily
possible in the market.
• The remedy to this problem is that the target capital
structure should be taken into consideration and not
the existing. and therefore, the calculation of WACC
should be adjusted accordingly.
Method of WACC
WACC = We*Ke +Wd*Kdt + Wp*Kp
where, We = weight of equity
Ke = cost of equity
Wd = weight of debt
Kdt = cost of debt after tax
Wp = weight of preferred stock
Kp = cost of preferred stock

The purpose of WACC is to determine the cost of each part of the


company`s capital structure based on the proportion of equity, debt
and preferred stock. Each components has a cost to the company .
Cost of equity(Ke)
The cost of equity is calculated using the CAPM which
equates the rate of return to volatility(risk and reward).

Ke = Risk free rate + Beta* market risk premium

It is the rate of return shareholders require.


Cost of debt and preferred stock
Since interest payments are tax deductible the cost of debt needs
to be multiplied by (1-TR) which referred to as the value of tax
shield.
This is not done in preferred stock because its dividends are paid
with after tax profit.

Kdt = Kd(1-TR)
where,
Kdt = after cost of debt
Kd = cost of debt
TR = tax rate
Difference between WACC and APV
1) Assumptions:
WACC:
1) All cash flows are perpetuities
2) A constant and unique tax rate
3) Constant leverage ratio
APV :
4) The project risk is equal to the average risks of other projects
within the firm
5) Corporate taxes are only important market imperfection at the
level of debt chosen.
6) All debt is perpetual
2) Based on value of tax shield associated with
use of debt
In the WACC we use free cash flow and discount rate
that is below the unlevered cost of capital. The lower
discount rate inflates the present value of the future free
cash flow by to account for the value of the tax shields
associated with chosen debt to equity ratio.

In the APV we value the free cash flow at the


appropriate discount rate for an unlevered firm which
gives us the correct present value of the tax shields
associated with the firm`s use of debt financing.
3) Application
WACC helps management evaluate whether the
company should finance with debt or equity by
comparing the cost of capital.

APV method is most useful evaluating companies or


projects with a fixed debt schedule, as it can easily
accommodate the side effects of financing such as
interest tax shields.
summary
APV WACC

Cash flows Unlevered unlevered

Discount rate Ra Rwacc

PV of financing effects yes no

You might also like