Frequently Asked Questions: Cost of capital

Question 1: Why should supplier credit not be considered as a source of financing like bank and other long-term debts or like equity, when calculating WACC?

Question 2: Can a reduction in net financial debt (prompted by a decrease in working capital) reduce WACC?

Question 3: We agree that the WACC is computed as a weighted average of the after-tax cost of debt and the cost of equity. What would you use as the cost of capital if the company has a net cash position ?

Question 4: Question 3: When calculating the cost of holding assets, what method should be used to calculate the return on equity?

Question 5: When calculating a company’s weighted average cost of capital (used for discounting free cash flows when valuing the company), should we take the cost of net debt before or after tax?

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Question 1:

Why should supplier credit not be considered as a source of financing like bank and other long-term debts or like equity, when calculating WACC?

Answer:

Operating debts do not bear interest and accordingly, cannot be included when computing WACC. In addition, when computing WACC it is the market value that should be weighted (not the book value), and the same goes for debt. Finally, the financial structure is not determined on the whole of the balance sheet, but on the sum of equity + net debt. Operating debts are included in working capital.

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Question 2:

Can a reduction in net financial debt (prompted by a decrease in working capital) reduce WACC?

Answer:

It is true that a reduction in working capital results in a reduction in net debt. It also results in an improvement in shareholder risk, as operating assets are financed by less debt and relatively more equity. On markets in equilibrium, a reduction in the share of debt in capital employed will be set off by a reduction in the cost of equity, leaving WACC unchanged (for more details see chapter 23 of the Vernimmen).

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Question 3:

We agree that the WACC is computed as a weighted average of the after-tax cost of debt and the cost of equity. What would you use as the cost of capital if the company has a net cash position ?

Answer:

There are two possible approaches, assuming that this cash is relatively structural and not cyclical.
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Question 4:

Question 3: When calculating the cost of holding assets, what method should be used to calculate the return on equity?

Answer:

Be careful – the cost of holding assets will only correspond to a return on equity if the company does not have debts. In the opposite case, the required rate of return on assets is the weighted average cost of capital.

The cost of equity is calculated as the rate of return for risk-free assets (government bonds) plus a risk premium that depends on the market risk of the asset.

For more information, see chapter 23 of the Vernimmen.

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Question 5:

When calculating a company’s weighted average cost of capital (used for discounting free cash flows when valuing the company), should we take the cost of net debt before or after tax?

Answer:

After tax, i.e. by multiplying the interest rate on the debt by (1 less the marginal corporate income tax rate) if the company does in fact pay income tax, which means that it will have to make profits and not have very large tax-loss carryforwards.

For more information, see chapter 23 of the Vernimmen.

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