What is the WACC with No Long Term Debt?
When calculating WACC, what if a firm has no long-term debt, but has current liabilities (Working Capital line items only)
How do we go about computing the D/E ratios? Or is the WACC basically the cost of equity..
Thanks.
Weighted Average Cost of Capital with No Long Term Debt
If a company has no long term debt - the WACC of a company will be its cost of equity - or the capital asset pricing model. This is because the WACC equation is the cost of debt * percent of debt in the capital structure * (1 - tax rate) + cost of equity * percent of equity in the capital structure. In this instance - the amount of debt would be 0.00% so WACC will just be the equity component which is the capital asset pricing model.
CAPM is calcuated as the risk free rate + Beta * (equity risk premium).
The equity risk premium is calcuated as the expected return on the market - the risk free rate. However, the the expected return on the market is notoriously difficult to calculate - therefore many bankers refer to the equity risk premium provided by Aswath Damodaran, a professor at NYU Stern.
Should We Include Working Capital Items?
No - working capital items should not be inlcuded as they are not interest bearing securities and therefore it is inappropriate to consider them as a "cost of capital."
Debt to Equity
Debt to Equity ratio is calcuated as total liabilities / total equity.
This would mean that working capital liabilities would be included in this number.
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You're a 3rd year analyst and don't know the answer to this?
if it has no debt AND you are not anticipating that the company will change its capital structure, then yes, the cost of equity = wacc. If the capital structure is expected to shift to a more debt heavy one, then wacc should be calculated using that assumption (wacc should reflect the forecast cap structure, not the historical one). If you expect the company to continue having no debt, you are actually best off just running a levered DCF instead of an unlevered DCF. Basically, here's what you would do:
It's worth noting that with this approach (as opposed to the unlevered), you benefit from avoiding explicitly dealing with the cash balances. Had you gone with unlevered, the cash balances that normally are netted against debt (which is conceptually problematic to begin with) would not have to be added back and a decision about how to model into the cost of capital would have to be made - the levered approach avoids this issue.
To further your understanding: You only account for the "interest bearing debt" in your WACC and capital structure calculations, which is typically the current portion of long term debt + long term debt. In allocating the costs you do not use D/E, you use Debt to Total Capital for the debt portion, and Equity to total capital for equity portion. Total capital = interest bearing debt + Preferred Equity + Equity
Ratio for cost of equity is: Equity/(interest bearing Debt+Preferred+Equity)%, and in your case it equals 1 or 100%. Multiply that by * Cost of equity. Since there is no interest bearing debt and assuming no preferred equity, WACC would equal your cost of equity. Your company has no interest bearing debt, therefore no cost is associated to it.
In the beta calculations using comparable companies to unlever the beta you use the "debt/equity" ratio of the comp, if the comp's debt is 0, the comp's un-levered beta equals the levered beta for that comp.
Since your D/E ratio for your company is "0", the re-levered beta will equal the average unlevered beta from your comps.
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