giorgio10

giatch Wrote:

> Any idea why? WACC should be higher than the cost
> of equity, not lower. The answer states "WACC is
> less than required return on equity. Incorrectly
> using the WACC (which is too low) in the FCFE
> model will overestimate equity value. Incorrectly
> using required return
> on equity (which is too high) in the FCFF model
> will underestimate firm value and
> equity value."

The explanation is absolutely correct. WACC will always (almost) be less than Re. Why? Becasue cost of debt is less than the cost of equity, usually, and the fact that you get a tax based discount (it is 1-tax rate) brings it lower. Bottom line, WACC will always be less than cost of equity for a levered firm. If a firm is zero leveraged, WACC = Cost of Equity.

Here is an example:
Before tax cost of debt: 7%; cost of equity 11%; Tax rate 30%; Debt ratio 40%

WACC = (0.11 * 0.6) + {0.07 * 0.4 * (1-0.3)} = 8.56%
Cost of equity = 11%