however the company has borrowed heavily and is in some financial difficulties its g 612427

Effect of entity default risk on its WACC

The formula for calculating the (post tax) WACC, as given in above, is

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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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