Two companies are same but one has DEBT and the other doesn't, which has the higher WACC?

I suppose the one without debt will have that higher WACC since debt is less expensive than equity but that doesn't make sense since if debt is less expensive, wont debt still factor into the WACC equation and cause WACC to be HIGHER?

 

It's a weighted average rate. An inclusion of a lower rate, with any weight, will lower the weighted average. You're not looking at dollar terms here. This is like a middle school concept wtf.

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Best Response

Assume the companies have similar costs of debt and equity. Company A has Debt and Company B does not. The formula for WACC as im sure you know is = CoE(E/D+E)+(1-tax rate)(CoD)(D/D+E). Assume CoE for both companies is 20% and CoD is 10%. Company B's WACC is 20%. Now for Company A the WACC will vary based on the weights. The important idea to remember however, is that if company A continues to add more debt then the respective costs of capital would increase, the weights change and the WACC can begin to increase. To start assume the company A has 80% equity and 20% debt, its WACC would be 17.2%, lower than Company B. If Company A begins to lever themselves then their WACC would at first begin to decrease but as the costs of both debt and equity rise then their WACC would rise as well. Think of WACC as a U-shaped curve.

 

Ik this was outdated but i got lost on the "To start assume the company A has 80% equity and 20% debt, its WACC would be 17.2%, lower than Company B. If Company A begins to lever themselves then their WACC would at first begin to decrease but as the costs of both debt and equity rise then their WACC would rise as well". Can anybody go over this?

 

^what of the unlevered company's cost of debt funding going forward? It is identical to the levered firm, but has no debt outstanding; therefore it could raise X dollars of new capital at a lower rate than the levered firm. So the levered firm has a lower trailing wacc, but for the purposes of financing going ahead, the unlevered firm has a lower potential wacc. Is this distinction made at all in common usage?

edit: in other words, is there a type of wacc or another measure which captures all potential sources of capital and their costs ex ante, as opposed to wacc ex post?

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As you lever up more the relative weights will change yes but the cost of levered equity Kle will also increase due to COFD, so you cannot ignore that aspect of equity financing that results in a higher overall cost of capital to the firm.

Doesn't make sense ot look at financing ex ante. My understanding is that your incremental marginal dollar of capital raised will be a spread to your existing capital structure's embedded cost of capital. Also, when you're discounting the cash flows using WACC, you should think of it as the investor's required rate of return given the risk of the cash flows. Thus, if you're cap structure is all equity, and thus a higher risk driving higher return, this will be reflected in the WACC calculated, notwithstanding in theory yes the unlevered firm may have access to cheaper fixed income capital since it has nothing on the BS. But for the purposes of valuation, risk/return expectations is what you're looking for so looking at this in an "ex ante" sense as you state above isn't really meaningful to the investor.

 

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