Debt and Cost of Capital





Kerry Back

Overview

  • Adding debt increases enterprise value because of the tax savings, up to a point.
  • Enterprise value is free cash flow discounted at the WACC.
    • Adding debt does not change FCF.
    • So adding debt must reduce the WACC.
  • The effect is through taxes, not just because debt is cheaper capital.

If there were no taxes …

  • WACC is

\[\frac{E}{E+D} r_E + \frac{D}{E+D}r_D\]

  • Increasing the debt share substitutes cheaper capital
  • Cost of debt will rise as debt share increases
  • Cost of equity will also rise as debt share increases
  • These effects exactly offset the use of cheaper capital

But there are taxes …

  • WACC is

\[\frac{E}{E+D} r_E + (1-t)\frac{D}{E+D}r_D\]

  • As without taxes, increasing the debt share
    • substitutes cheaper capital
    • but makes debt and equity more expensive
  • The net effect with taxes is to lower the WACC