ABV ABV Discount Rates & Capital Structure

Question 1

What does WACC stand for in the context of business valuation?

Accepted Answer

Weighted Average Cost of Capital

Answer

WACC is the blended cost of all capital sources (equity and debt) weighted by their proportions in the company's capital structure.

Question 2

In a WACC calculation, why is the after-tax cost of debt used rather than the pre-tax cost?

Accepted Answer

Because interest expense is tax-deductible, reducing the effective cost of debt to the company

Answer

The tax shield on interest payments reduces the company's effective borrowing cost, so the after-tax rate reflects the true economic cost of debt financing.

Question 3

When using WACC to value a privately held company, how are the weights for debt and equity typically determined?

Accepted Answer

Using market value weights (or targeted capital structure) rather than book value weights

Answer

Market value weights are theoretically correct because they reflect the current economic claims of each capital source, not historical cost.

Question 4

What happens to WACC when a company increases its leverage (debt ratio), assuming no change in business risk?

Accepted Answer

WACC initially decreases due to the tax shield but may increase at high leverage due to financial distress costs

Answer

The Modigliani-Miller framework shows that debt's tax shield lowers WACC at moderate leverage, but distress and agency costs can reverse this at high leverage.

Question 5

Which of the following is the correct formula for the after-tax cost of debt in a WACC calculation?

Accepted Answer

Kd = Pre-tax yield × (1 – Marginal Tax Rate)

Answer

The after-tax cost of debt multiplies the pre-tax yield by one minus the marginal tax rate to capture the interest tax deduction benefit.

ABV - Accredited in Business Valuation Practice Test

ABV - Accredited in Business Valuation Practice Test

ABV ABV Discount Rates & Capital Structure