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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

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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