hi everyone, i am confused about a particular paragraph from the kaplan schweser books. pleasehelp to understand the reasoning in the below par. of why wacc is less sensitive to leverage changes? this seems odd since cost of debt is included in wacc but excluded from cost of eqiuty. thanks! “Free cash flow to the firm (FCFF) can be used to value the firm as a whole and free cash flow to equity (FCFE) can be used for equity. FCFF is usually favored if the firm is going to significantly change its capital structure. The reason is that the discount rate used for FCFF valuation, the weighted average cost of capital (WACC), is less sensitive to leverage changes than the discount rate used for FCFE valuation, the cost of equity.”
I think they’re is an optimal level, for a firm, of debt and equity capital structure. So at a certain point equity captial becomes more and more expensive and I firm would find it better or cheaper to employ/raise debt financing. Therefore equity capital alone is more sensitive to leverage, whereas WACC is average over debt and equity and isn’t nearly as sensitive to changes in the capital structure of a firm. If that makes any sense. That’s just the way I look at it. Any other ideas…?
also remember from DDM or Gordon Growth Model, that output is VERY sensitive to the inputs, ie: r-g in the denominator…small changed to r or g have big changes in the result
CFA rhythm: the DDM and GG are for valuing a firm, not for finding cost of capital. the sensitive denominator exists in valuation of the hwole firm too (i.e. wacc - g). reggie: i think i sorta see what youre saying…are you just implying that above a certain optimal point of debt, equity capital increases more as equity becomes more risky. therfore, cost of equity increases a lot but the increase in wacc is “held back” because it is proporitonally added with cost of debt, which does not rise as much. kind of a stretch haha
Bingo, and yes I agree it’s kind of a stretch. It’s just the way I rationalized it in my head, I don’t recall ever reading why equity capital alone is more sensitive to leverage than WACC.
its on page 313 of book 3 of schweser. if anyone else has input on this it would be much appreciated.
If you look at the levered cost of equity as follows: r = r* + (r*- i)(D/E)(1-tx) - (This will not be on the exam) - then the WACC will tend to be quite a bit more sensitive to changes in capital than the cost of equity. Thus rendering Schweser wrong… But this is completely besides the point. Both FCFF and FCFE can be used for firms with upcoming capital structure changes. FCFF just happens to be more convenient. (I would imagine that CFAI prefers FCFF for changing structures, i mention this incase it is on the exam) On convenience: If you know that a firm’s capital structure is about to undergo some major changes, this should affect the value of the equity piece (hopefully in a positive manner). Evaluating equity value using FCFE alone may not take this oncoming change (unless you modify all the financial statements accordingly) into account, leading to a useless number. Easier to use FCFF (which does not count interest payments that are about to change) to find the firm value and then subtract the value of debt. This will give you an accurate value of the equity. Of course, you would adjust the WACC to represent the future structure and true upcoming cost of capital. So, FCFF may be preferable, but not due to the discount rate. It is simply more user friendly.
I’m thinking that the reasoning in the Schweser example would be that if a firm issues more debt, they will thus take on more interest expenses etc. This makes the firm less profitable and as a result the premium required on the return of equity increases. Debt claims will come before equity claims and could be another reason why the required equity risk premium would increase. Lastly, the cost of debt and wcc include the tax shield that comes with debt financing. Check out in which context Schweser says that the equity return requirement is more sensitive. The tax shield is a positive thing up until we reach the threshold. For more info on this check out the MM Theories…