Weighted Average Cost of Capital (WACC) Question 2?

Question

I understand why market value of all capital should be used when calculating the WACC for a future project, but I don't understand why it should be used in valuing a firm today.

For Example:

Time = 0

Assets = 1,000 return 8% required return 8%
Debt = 500 return 8% required return 8%
Equity = 500 return 8% required return 8%

In this simple example, the returns and required returns are equal, therefore the market values equal book values.

If the required return of the debt increases to 10%, then the value of the liability decreases to 400.

Is it not good when the value of a liability decreases for the company that is paying on the debt? If this happens, would the value of the assets not increase because the company is paying a yield below market yields?

But, based on market values of 400 for debt and 500 for equity, the WACC would increase resulting in a decline in the value of the assets.

I would really appreciate it if someone could help me out.

Answer 1

In theory, the value of the firm today is based on the firm's future cash flows discounted at WACC. WACC is based on market value of its financing.

In the default scenario, WACC is equally financied by debt and equity with a cost to each (ignoring tax shield on debt) of 8%.

In the second scenario, the market value of debt goes down as required rates go up. Remember, there is an inverse relationship between interest rates and the price of the instrument. Now the company is 44% financed by 10% debt and 56% financed by 8% equity - for a total firm WACC of 8.89%.

Yes, the weighting goes down - but at a higher cost. So, no, it is not a good thing when the value of the liability decreases. Remember the market value has gone down but the BOOK value is still at cost. So they raise $500 worth of debt at 8%, but the company is being penalized now because it is riskier now and requires 10% returns on debt.