ABV ABV Discount Rates & Capital Structure 1 — Questions and Answers
Question 1: What does WACC stand for in the context of business valuation?
- Weighted Average Capital Cost
- Weighted Average Cost of Capital (Correct answer)
- Working Asset Capital Calculation
- Weighted Adjusted Cash Contribution
Correct answer: Weighted Average Cost of Capital
WACC is the blended cost of all capital sources (equity and debt) weighted by their proportions in the company's capital structure.
Question 2: In a WACC calculation, why is the after-tax cost of debt used rather than the pre-tax cost?
- Because debt holders pay no taxes
- Because interest expense is tax-deductible, reducing the effective cost of debt to the company (Correct answer)
- Because the IRS requires after-tax reporting for all debt instruments
- Because pre-tax cost of debt is unavailable from market data
Correct answer: Because interest expense is tax-deductible, reducing the effective cost of debt to the company
The tax shield on interest payments reduces the company's effective borrowing cost, so the after-tax rate reflects the true economic cost of debt financing.
Question 3: When using WACC to value a privately held company, how are the weights for debt and equity typically determined?
- Using the company's book value of debt and equity only
- Using market value weights (or targeted capital structure) rather than book value weights (Correct answer)
- Using the industry average debt-to-equity ratio always
- Using the face value of all outstanding debt instruments
Correct answer: Using market value weights (or targeted capital structure) rather than book value weights
Market value weights are theoretically correct because they reflect the current economic claims of each capital source, not historical cost.
Question 4: What happens to WACC when a company increases its leverage (debt ratio), assuming no change in business risk?
- WACC increases because equity becomes riskier as leverage rises
- WACC initially decreases due to the tax shield but may increase at high leverage due to financial distress costs (Correct answer)
- WACC remains constant regardless of capital structure changes
- WACC decreases indefinitely as more debt is added
Correct answer: WACC initially decreases due to the tax shield but may increase at high leverage due to financial distress costs
The Modigliani-Miller framework shows that debt's tax shield lowers WACC at moderate leverage, but distress and agency costs can reverse this at high leverage.
Question 5: Which of the following is the correct formula for the after-tax cost of debt in a WACC calculation?
- Kd = (Interest Expense / Total Assets) × Tax Rate
- Kd = Pre-tax yield × (1 – Marginal Tax Rate) (Correct answer)
- Kd = Risk-Free Rate + Credit Spread – Tax Rate
- Kd = Bond coupon rate / Book value of debt
Correct answer: Kd = Pre-tax yield × (1 – Marginal Tax Rate)
The after-tax cost of debt multiplies the pre-tax yield by one minus the marginal tax rate to capture the interest tax deduction benefit.
Question 6: In business valuation, when is WACC preferred over the equity discount rate (cost of equity) as the discount rate?
- When valuing equity directly using dividends only
- When valuing debt-free, cash-free earnings
- When valuing invested capital (MVIC) using debt-free cash flows such as FCFF (Correct answer)
- When the company has no debt outstanding
Correct answer: When valuing invested capital (MVIC) using debt-free cash flows such as FCFF
WACC discounts free cash flow to the firm (FCFF), which is available to all capital providers, yielding enterprise value (MVIC).
ABV ABV Discount Rates & Capital Structure 1
What does WACC stand for in the context of business valuation?