EV/EQ Changes
If you increase equity, what changes are made in the WACC formula?
- My thought was that cost of equity would go down because of levered beta but the amount of equity increases. Also, because you have more debt and debt/equity goes down, does the cost of debt go down as well?
If you increase preferred stock, what changes are made in the WACC formula?
- If preferred stock increases is it considered debt in the levered beta so cost of equity increases? Does it affect cost of debt or does it only affect amount of preferred stock?
When you say “increase equity” I’m assuming you mean increasing equity as a percentage of the cap. structure.
Increasing equity in this way will: (1) likely increase your overall WACC, as equity is almost always more expensive than post-tax debt nowadays. (2) the above may be slightly offset by a lower beta indication (if you are using a conventional comp regression to ascertain beta in CAPM) as less debt usually results in a lower summary statistic of “relevered” beta in the comp set. (Reply to this comment and I can expand on this point more).
Increasing preferred stock in the cap structure essentially does the opposite of the above. Preferred stock is treated as debt in capital asset pricing theory so you would have a lower wacc (but the cost of the preferred stock should be the coupon rate, which might be slightly higher than like a AA or A or BBB composite proxy for pretax cost of debt) and it also should result in a slightly higher beta indication when you relever the comps.
I think the answer to your final question, in terms of your client’s WACC, would be to (1) get to required return on equity in the conventional way, (2) get to post tax cost of debt in a conventional way (look at borrowing rates for the comps), and (3) add an additional component of the cap structure w the preferred stock and say its cost is the coupon rate. This way you have 3 capital sources (I only recommend this if preferred stock is significant in the larger scheme of all this). Another important factor is this might only be necessary if the coupon in (3) and the debt pricing in (2) are materially different, otherwise you’re getting to the same spot. So just use =SUMPRODUCT() in excel to figure this out w the array having 3 dimensions as opposed to the conventional 2 in CAPM.
I just want to make sure so increase in equity decreases CAPM but percentage of equity goes up so WACC goes up. Does it in any way affect the coupon rate for bonds?
For preferred stock, since it is treated as debt does CAPM go up and percentage of Preferred stock goes up? Again, does it in any way affect the price of bonds?
I’m assuming when you say “CAPM [goes] up” you mean the WACC goes up. (1) short answer is no. More equity in the cap structure doesn’t impact the debt coupon pricing. (2) The second one could be yes, but it’s more likely no; if the coupon on the preferred stock is higher than your required return on equity, then yes, WACC would go up. However, preferred stock yields are generally lower than the cost of equity, thus preferred stock generally reduces your WACC. Lastly, preferred stock shouldn’t impact the debt coupon pricing (generally because preferred stock is subordinated to debt).
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