Question

How does a higher beta affect WACC and why? How does a drop in the bond market effect WACC and why?

Answer 1

Cost of Equity = Risk free Rate + Beta*(Market Rate of Return – Risk-free Rate)
The after tax cost of debt = (Yield to maturity on the bond)*(1 – Tax Rate)
Weighted Average Cost of Capital (WACC)= (After Tax Cost of Debt)*(Weight of Debt) + (Cost of equity)*(Weight of Equity)

Case 1: Higher beta:
Cost of Equity = Risk free Rate + Beta*(Market Rate of Return – Risk-free Rate)
When the value of beta increases, the value of the cost of equity will also increase. This will increase the WACC.

Case 2: Drop in the bond market
When there is a drop in the bond market, there will be a decrease in the WACC. This is because, a drop in the market will decrease the after tax cost of debt .