Effect of entity default risk on its WACC
The formula for calculating the (post tax) WACC, as given in above, is
where:
t is the rate of tax relief available on the debt servicing payments
D is the pre-tax cost of debt;
E is the cost of equity;
g is the gearing level (i.e. the ratio of debt to equity) for the sector.
The cost of equity is calculated as follows:
Cost of equity = risk-free rate + (levered beta (ß*) × market risk premium)
Assume that the WACC of a typical sector participant is as follows:
|
Cost of equity |
|
|
risk free rate |
4% |
|
levered beta (ß) |
1.1 |
|
market risk premium |
6% |
|
cost of equity after tax (market risk premium × ß + risk-free rate) |
10.6% |
|
Cost of debt |
|
|
risk free rate |
4% |
|
credit spread |
3% |
|
cost of debt (pre-tax) |
7% |
|
cost of debt (post-tax) |
5.25% |
|
Capital structure |
|
|
debt / (debt + equity) |
25% |
|
equity / (debt + equity) |
75% |
|
tax rate |
25% |
|
post-tax cost of equity (10.6 × 75%) |
8% |
|
post-tax cost of debt (5.25 × 25%) |
1.3% |
|
WACC (Post tax, nominal) |
9.3% |
* The beta is explained in above.
However, the company has borrowed heavily and is in some financial difficulties. Its gearing ratio is 75% and its actual cost of debt, based on the market price of its listed bonds, is 18% (13.5% after taking account of tax at 25%). This makes its individual post-tax WACC 12.8% (10.6 × 25% + 13.5 × 75%). This is not an appropriate WACC for impairment purposes because it does not represent a market rate of return on the assets. Its entity WACC has been increased by default risk.
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