1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? The WACC of a firm is the overall required return on the firm as whole. It is the discount rate to use for cash flows with risk that is similar to the overall firm. The WACC lets you see how much interest the company has to pay for every dollar it finances. The WACC of a firm increases at the Beta and rate of return on equity increases.
A decrease in WACC indicates a decrease in valuation and a higher risk. When the capital structure changes, the WACC will change in a U shape pattern. Debt is considered less risky than equity, so equity cost is usually higher than the cost of debt. The lowest WACC is the optimal capital structure. •Joanna used the book value of equity when she should have used the market value of equity. Which is equal to the number of outstanding shares multiplied by the price. This will change her weight of debt calculation. She used the book value of debt, which is ok because it is usually close to the market value. •The cost of debt she used was the total interest expense for the year divided by the average debt balance. She should have divided the total interest expense by the long term debt of the company. •The tax rate that she used was the state tax of 3% to the US statutory tax rate of 35%. She should have divided the income tax paid by the taxable income. •Cost of Equity – She used a 20-year treasury bond rate as the risk free rate.