3.10 Changes in the Cost of Capital
What factors may cause the WACC to rise (or fall)? There are both financial and economic causes. What formula or models will you employ to describe the effects of each of the following possible causes?
Financial Causes for the WACC to change
1. A decision on the part of the company’s management to alter the capital structure from its current proportions. For example, the use of equity whether external or internal equity will raise the WACC, if the company has any debt at all presently.
2. A change in the corporation’s credit rating in the face of issuing more debt. (Note: This will affect the firm’s Beta.)
3. A change in tax laws may affect the after-tax cost of debt. (This will have no effect on other capital component costs.) The formula to apply in this analysis is:
K Debt = I (1 – T).
Economic Causes for the WACC to change
4. Market changes, including:
a. A change in the bond yield curve due to inflation or lack thereof, and Federal Reserve policies and activities. What will that do to the bond’s YTM on its marginal debt?
b. Bond market Credit Spreads will fluctuate with macroeconomic conditions. A Credit Spread is the difference in yield between a Treasury and a lower rated bond of equivalent maturity. Credit Spreads tend to widen when the economic outlook worsens and narrow when the picture is more optimistic. What may happen to the firm’s marginal YTM – its marginal cost of debt? A firm’s marginal YTM will rise when economic conditions worsen.
c. A change in the CAPM, which provides the required return used by theoreticians as a discount rate. As noted in our discussion below concerning the CAPM, changes may come about in the security market line due to changes in short-term interest rates (RF) and changes in the Market Risk Premium (RM – RF), which has a similar impact and cause as do credit spreads.
If the corporation’s WACC went down, the NPV on prospective projects would be relatively higher; more projects would be accepted! Similarly, the hurdle rate would be lower and, under both the IRR and MIRR, more projects would be accepted!