How do interest rates affect the weighted average cost of capital (WACC) calculation?

By Jean Folger AAA
A:

Weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds and any other long-term debt. It is calculated by multiplying the cost of each capital source by its relevant weight, and then adding the products together to determine the WACC value.

Internal and external factors can cause problems for investors and analysts trying to assess the performance of a firm over time and in comparison with other firms in the industry. One external factor is the fluctuation of interest rates. The Federal Reserve Bank (the Fed) moderates long-term interest rates by targeting the federal funds rate - the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank overnight.

The Fed attempts to align the effective federal funds rate with the targeted rate by making additions to or subtractions from the money supply through open market operations (the buying and selling of U.S government securities, or Treasury bills).

As interest rates are moderated, it can cause fluctuations in the risk-free rate, the theoretical rate of return for an investment that has no risk of financial loss. This can affect a firm's WACC because the risk-free rate is an important factor in calculating the cost of capital. As the interest rate on debt fluctuates, it can be challenging for a company to predict the future costs of capital. As a result, a company can end up with greater or lesser capital costs than expected because of fluctuations in interest rates. A firm's cost of debt must be updated frequently as the cost of debt reacts to fluctuations in interest rates.

Other external factors that can affect WACC include corporate tax rates, economic conditions, and market conditions.

RELATED FAQS

  1. What are the main components of the Federal Reserve's balance sheet?

    Find out which items are listed as assets and liabilities on the balance sheet of the Federal Reserve, and how to read the ...
  2. What's more important, cash flow or profits?

    Learn about the different effects that cash flow and profit have on a business so you can decide which aspect to focus on.
  3. Which leverage ratios are most useful for analyzing manufacturing companies?

    See which leverage ratios investors and creditors are likely to use when analyzing the debt burdens for manufacturing companies.
  4. What are some examples of how cash flows can be manipulated or distorted?

    Read about some of the most common accounting techniques that can be used to manipulate the operating cash flow on a company's ...
RELATED TERMS
  1. Weighted Average Cost Of Capital - WACC

    A calculation of a firm's cost of capital in which each category ...
  2. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...
  3. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  4. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  5. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  6. Working Capital

    This ratio indicates whether a company has enough short term ...
Related Articles
  1. Useful Balance Sheet Metrics
    Investing Basics

    Useful Balance Sheet Metrics

  2. Understanding The Federal Reserve Balance ...
    Fundamental Analysis

    Understanding The Federal Reserve Balance ...

  3. Investors Need A Good WACC
    Bonds & Fixed Income

    Investors Need A Good WACC

  4. SIC Vs. NAIC -An Introduction To Industry ...
    Fundamental Analysis

    SIC Vs. NAIC -An Introduction To Industry ...

  5. Investing In New York City REITs
    Mutual Funds & ETFs

    Investing In New York City REITs

Trading Center