ABV Discount Rates & Capital Structure Flashcards

What does WACC stand for in the context of business valuation?

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.

In a WACC calculation, why is the after-tax cost of debt used rather than the pre-tax cost?

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.

When using WACC to value a privately held company, how are the weights for debt and equity typically determined?

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.

What happens to WACC when a company increases its leverage (debt ratio), assuming no change in business risk?

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.

Which of the following is the correct formula for the after-tax cost of debt in a WACC calculation?

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.

In business valuation, when is WACC preferred over the equity discount rate (cost of equity) as the discount rate?

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).