Interest Rates and Other Factors That Affect WACC

Various internal and external factors can alter the weighted average cost of capital (WACC) for a business over time. One of these external factors is the fluctuation of interest rates.

Key points to remember

  • The weighted average cost of capital (WACC) is the average after-tax cost of a company’s various sources of capital.
  • The interest rate paid by the company is equal to the risk-free rate plus the default premium for the company.
  • When the Fed increases interest rates, the risk-free rate immediately increases, which increases the firm’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 sources of capital. He understands ordinary actions, favorite stock, bonds and other debts. The WACC is calculated by multiplying the cost of each source of capital 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 a huge influence on short-term interest rates and the WACC through the federal funds rate. The federal funds rate is the interest rate in which a bank lends funds held at the Federal Reserve to another bank overnight.

As the Fed makes interest rate adjustments, this leads to changes in the risk-free rate, the theoretical rate return rate for an investment without risk of financial loss. An increase or decrease in the federal funds rate affects a company’s WACC because the risk-free rate is a critical factor in calculating the cost of capital. The interest rate paid by the company is equal to the risk-free rate plus the default bonus for the firm.

How Higher Interest Rates Increase 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 company’s debt default premium was 1%, then the interest rate used to calculate the company’s WACC was 3%. If the Fed raises rates to 2.5% and the corporate default premium remains at 1%, the interest rate used for the WACC would rise to 3.5%. A higher cost of capital for the company could also increase the risk of default. This would increase the default premium and further increase the interest rate used for WACC.

The longer the time to maturity of a company’s debt, the longer it will take for the full effect of rising 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 as interest paid on debt is tax deductible. Higher corporate taxes reduce the WACC, while lower taxes increase the WACC.

WACC’s response to economic conditions is more difficult to assess. The direct effect of good economic conditions is to reduce the risk of default, which reduces the default premium and the WACC. However, it also makes it more likely that the Fed will eventually raise interest rates and raise the WACC.

Market conditions can also have various consequences. For example, increase volatility on the stock market will increase the risk premium demanded by investors. This increases the cost of raising additional capital for the business. However, higher volatility is also likely to decrease the value of existing shares, making it cheaper for the company to repurchase shares.

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