Various internal and external factors can change the weighted average cost of capital (WACC) for a company over time. One such external factor is the fluctuation of interest rates.
Key Takeaways
- The weighted average cost of capital (WACC) is the average after-tax cost of a company's various capital sources.
- The interest rate paid by the firm equals the risk-free rate plus the default premium for the firm.
- When the Fed hikes interest rates, the risk-free rate immediately increases, which raises the company's WACC.
- Other external factors that can affect WACC include corporate tax rates, economic conditions, and market conditions.
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources. It includes common stock, preferred stock, bonds, and other debt. WACC is calculated by multiplying the cost of each capital source by its weight. Then, the weighted products are added together to determine the WACC value.
The Impact of Interest Rates
The Federal Reserve (Fed) has an enormous influence over short-term interest rates and WACC through the fed funds rate. The fed funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank overnight.
As the Fed makes adjustments to interest rates, it causes changes in the risk-free rate, the theoretical rate of return for an investment that has no risk of financial loss. An increase or decrease in the federal funds rate affects a company's WACC because the risk-free rate is an essential factor in calculating the cost of capital. The interest rate paid by the firm equals the risk-free rate plus the default premium for the firm.
How Higher Interest Rates Raise a Company's WACC
When the Fed raises interest rates, the risk-free rate immediately increases. If the risk-free interest rate was 2% and the default premium for the firm's debt was 1%, then the interest rate used to calculate the firm's WACC was 3%. If the Fed raises rates to 2.5% and the firm's default premium remains 1%, the interest rate used for the WACC would rise to 3.5%.
A higher cost of capital for the company might also increase the risk that it will default. That would raise the default premium and further increase the interest rate used for the WACC.
The longer the time to maturity on a firm’s debt, the longer it will take for the full impact of higher rates to be felt.
Other Factors That Affect WACC
Other external factors that can affect WACC include corporate tax rates, economic conditions, and market conditions. Taxes have the most obvious consequence because interest paid on debt is tax deductible. Higher corporate taxes lower WACC, while lower taxes increase WACC.
The response of WACC to economic conditions is more difficult to evaluate. The direct effect of good economic conditions is to lower the risk of default, which reduces the default premium and the WACC. However, that also makes it more likely that the Fed will eventually raise interest rates and increase WACC.
Market conditions can also have a variety of consequences. For example, increasing volatility in the stock market will raise the risk premium demanded by investors. That increases the cost of raising additional capital for the firm. However, higher volatility is also likely to decrease the value of existing equity, which makes it less expensive for the firm to buy back shares.
