WACC Components
DEBT
Advantages:
- usually cheaper than equity
- no loss of control (voting rights)
- upper limit is placed on share of profits
- floatation costs are typically lower than equity
- interest expense is tax deductible
Disadvantages:
- legally obliged to make payments no matter how tight the funds on hand are
- in the case of bonds, full face value comes due at one time
- taking on more debt = taking on more financial risk (more systematic risk) requiring higher cash flows
The firm's debt component is stated as kd and since there is a tax benefit from interest payments then the after tax WACC component is kd(1-T); where T is the tax rate.
Equity
Advantages:
- no legal obligation to pay (depends on class of shares)
- no maturity
- lower financial risk
- it could be cheaper than debt, with good prospects of profitability
Disavdantages:
- new equity dilutes current ownership share of profits and voting rights (control)
- cost of underwriting equity is much higher than debt
- too much equity = target for a leveraged buy-out by another firm
- no tax shield, dividends are not tax deductible, and may exhibit double-taxation
Cost of new equity should be the adjusted cost for any underwriting fees terme flotation costs (F)
Ke = D1/P0(1-F) + g; where F = flotation costs, D1 is dividends, P0 is price of the stock, and g is the growth rate.
More to come: (K preferred shares, WACC equation, EVA, MCC, MCC schedule and demonstration, IOS schedule and demonstration, MCC/IOS schedules)
Read more about this topic: Marginal Cost Of Capital Schedule
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