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Hi David,

In the WACC explanation you mention that equity is costlier as it is subordinate claim hence riskier. Since the firm has no obligation to pay equity holders (they get returns only if value of firm is more than the debt of the firm) why would equity be riskier . In fact isn't debt riskier as firms have a obligation to pay debt holders? In keeping with this logic isn't debt costlier

Ravi
 

David Harper CFA FRM

David Harper CFA FRM
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#2
Hi Ravi,

That's really interesting, I can't disagree with you. WACC means to reflect the firm's expected (average) cost of capital as a function of capital providers' expected returns. From an income statement perspective, you are surely correct: debt must be paid, and shareholder get the volatile residual, if any.

But the point of EVA (and RAROC for that matter) is that although equity doesn't appear on the income statement, and doesn't represent a periodic (i.e., urgent) outlay, it has a cost. So, in classic WACC: the *average* or expected costs are really a function of expected returns owed to the capital providers. So, I can't disagree with your firm-centric view. But from the capital providers perspective, the equity holders have a right to expect more compensation for "taking a back seat" to bondholders - they are subordinate to bondholders. They are promised nothing but they expect high returns; bondholder are promised less and expect little upside. (the other reason the debt is cheaper to the firm is the tax shield). But my statement clearly is *not true* at high leverage (recall the optimal WACC curve): after a certain high-leverage, the cost of marginal debt is higher than equity, even prohibitive.

So, yea I parrot classic WACC taught in finance. Namely, that shareholders, being residual and promised nothing, should expect a higher return. And that expected return, combined with the lack of a tax shield (which debt gets) makes the equity more expensive.

But that said, IMO, there is practical truth in what you say. Lots of academic research is spent on the question of why firms don't act like the WACC theory above. I suspect it's partly because of the point you've made. I'm not sure the WACC really factors in the "liquidity" (risk) of the necessary payment versus the optionality of deferring returns to shareholders (Why do new startup firms tend to finance all-equity, isn't that the "most expensive" capital structure?)

...as i think about it, your point (maybe?) relates to a liquidity idea (needing to pay bondholder this year is riskier versus not needing to pay shareholders immediately) that doesn't seem to be captured in classic WACC. The WACC is a long-term average (it allows for returning zero to shareholders in the short run and a lot in the long run)

David
 
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