THE COST OF DEBT
WACC is calculated using the marginal cost of corporate debt, that is, the yield the company would incur for borrowing an additional dollar. Interest expense is an inaccurate reflection of a corporation’s true cost of debt. Nor is it a marginal cost. The average coupon currently paid by a corporation is the result of yields and credit rating at the times of issuance and may not reflect the market environment or corporate credit quality.
Credit quality and corporate bond ratings are the primary determinants of the cost of debt, and they are influenced by factors such as size, industry, leverage, cash flow and coverage, profitability, and numerous qualitative factors.
WACC is based on an after-tax cost of debt. Higher degrees of financial leverage and cash flow volatility will lead to lower expected values for each dollar of tax shield. There will be fewer profits to shield, a loss in time value from loss carry forwards, and an increased risk of financial distress. Company-specific stochastic solutions are perhaps the best approach to estimating this effect. However, as a short-cut method, this effect can be approximated by analyzing risk-laden corporate debt as risk-free debt less a put option on the assets of the firm, with a strike price equal to the face value of the debt.
Based on option valuation framework, the probability of being able to utilize the interest tax shield decays under increased leverage, volatility, and duration. At the debt’s maturity equity-holders ...