Question

We want to calculate WACC for a company based on book values and market values

We know that the short term debt is 100000 in balance sheet

We also know that the short term debt is 1 MILLION EURO bank loans at 6% and helps company to finance receivables and inventories on a temporal basis.

We also know that this year, its level is close to zero.

You must include it in Wacc and why not?

You also know that long term debt consists of 9% coupon bonds, with market price 93 usd , face price 100 eur and YTM 12%

9% is sth necessary for calculating Wacc?What does it mean?

Answer 1

Short term debt

Capital generally refers to the fund that is used by a firm to fund its long term requirements. According to the definition, capital includes equity (and preferred shares) and long term debt.

Short term loans are used to fund short term requirements. We don’t classify short term loans or liabilities under capital.

Hence, you don’t have to include the short term debt while calculating WACC. Only include cost of equity, cost of preferred stock and cost of long term debt while calculating WACC.

Long term debt

The true cost of debt is expressed by the formula:

After-Tax Cost of Debt = Cost of Debt x (1 – Tax Rate)

Estimating the Cost of Debt: YTM

The approach is to look at the current yield to maturity or YTM of a company’s debt. If a company is public, it can have observable debt in the market. An example would be a straight bond that makes regular interests payments and pays back the principal at maturity. This approach is widely used when the company being analyzed has a simple capital structure, where it does not have multiple tranches of debt, including subordinated debt or senior debt for example, with each having significantly different interest rates.

Cost of Debt of a Bond PV PV of Par Value+PV of Coupon Payments Par Value py CouponCoupon Coupons +FV (1+YTM)(1+YTM)2(1+YTM)2 Coupon Payment Where; PV is the price of the bond FV is the par value Coupon Payment Solve for YTM Coupon Payment Your cost of debt is the YTM

Simply we can say that 9% is what we are giving to debt holders but they expect 12% return from us. It is evident from market value of our bond that is below our par value. which means that what we are giving is less that what debt holders expect from us.

And cost of debt is what debt holders expect from us based on multiple factors like risk factor etc and not what we as a company give to them hence 9% is not a relevant rate for us for wacc calculations.