3.6 Weighted Average Cost of Capital (WACC)

XYZ Corp

As of 12.31.xx  

(000)

On the next page, we present the solution to XYZ Corp’s WACC.  On that same page, we also ask (and solve) the following additional question: What if the firm increased its common equity capital by $10,000?

One will note from the table above that there is a kind of hierarchy of costs for the various capital components. When one evaluates the cost of capital, one must view it from the point of view of the corporation (and not the investor) that incurs the cost of raising the capital.

You will note that debt is the lowest-cost capital component among those listed herewith, with preferred, internal, and external common equities higher respectively. (We are ignoring current liabilities herewith.) This hierarchy is so simple because interest on bonds must be paid before any cash dividends on preferred and common stock may be paid. Debt is senior to other capital components in the worst-case scenario of bankruptcy/liquidation of the firm. Although of secondary importance, interest is also tax deductible, which lowers its cost to the corporation even more so.

No common dividends may be paid until preferred dividends are paid first and, in the case of Cumulative Preferred stock, all “arrears” (i.e., past dividends not paid) must be paid in full before any common dividends may be paid.

Of course, common shareholders, while holding the riskiest of the firm’s securities, get the most upside as they share an interest in all residual profits and may benefit from growth in earnings and distribution of increasing dividends. As opposed to retaining earnings, issuing common shares imposes upon the firm substantial “flotation costs,” which add to the cost of common shares versus, in comparison, retaining earnings. In contrast, preferred dividends are usually fixed.

To summarize, debt is cheapest because interest must always be paid in full and timely.   Interest is also tax-deductible to the corporation. Preferred dividends must be paid before any dividends are paid on common shares. From the point of view of the corporation, retaining earnings, which would be the property of the common shareholder, is a cheaper source of capital funds than raising external common equity funds, which entail substantial flotation costs. Please refer back to the “Cost of Capital” summary page above.

What does the “Optimal Capital Structure” of the firm mean?

There is no universal answer to this question; it will depend on the factors below.  However, we must note that the firm’s objective will be to reduce its WACC as much as possible without risking bankruptcy; how much will depend on managerial and shareholder risk tolerances.

What (four) factors affect the optimal structure?

1. Management risk profiles (Using debt increases the firm’s financial risk)
2. Shareholders’ risk profiles (Investing in a debt-ridden company implies investor risk)
3. Industry characteristics:
   • Magnitude of P, P, & E investment (some industries, e.g., electric utilities, have intense capital investments).
   • Stability of EBIT
     • Consider also the variability longitudinally of the TIE Ratio.
     • “Times Interest Earned” = EBIT ÷ Interest Expense.
4. Relative capital costs in the market. There are times when stocks and bonds relative costs increase or decrease, i.e., the credit spread.^[1]

In the end, we say (ridiculously!) that the firm’s existing capital structure is ideal; otherwise, rational managers would not have executed it!

• How does the Optimal Capital Structure affect the firm’s choice of new financing sources?
• What does the “Marginal Cost of Capital” mean?
  • It is the capital cost of the next dollar financed (see below).