WACC for geared and ungeared companies

Yasaswi Gomes new (Finance ) (4469 Points)

05 June 2023  

Hi all!

 

I was just going through investment appraisal techniques. I found out that Geared company's WACC

    Yasaswi Co. (Geared Company)  
    Cost of Capital   Amount   Weights
Term loan 10%   0   0
Debenture 9%   200   0.5
Preference Capital 12%   0   0
Equity Capital 13%   200   0.5
Retained Earnings 13%   0   0
        400   1
    WACC   11%    
    IRR    149%    
    Debt   200    
    Equity   200    
    Capital Gearing 50%    

 

is higher due to their costs of capitals than an ungeared company like below:

 

    Yasaswi Co. (Ungeared Company)  
    Cost of Capital   Amount   Weights
Term loan 10%   100   0.01
Debenture 9%   100   0.970001
Preference Capital 12%   100   0.01
Equity Capital 13%   100   0.01
Retained Earnings 13%   0   0
        400   1.000001
    WACC   9%    
    IRR    149%    
    Debt   300    
    Equity   100    
    Capital Gearing 75%    

 

Lower WACC can be vice-versa between them as well as it depends upon your capital costs. The IRR here is 149% in both the scenarios as its based on Outflows and Inflows. 

Some workings here:

Year CF DF @ 10% DCF DF @ 15% DCF RATE 10% 15%
0 -100 1 -100 1 -100      
1 200 0.90909091 181.818182 0.86956522 173.913043      
2 100 0.82644628 82.6446281 0.75614367 75.6143667      
3 50 0.7513148 37.56574 0.65751623 32.8758116      
4 10 0.68301346 6.83013455 0.57175325 5.71753246      
NPV ₹ 208.86 ₹ 188.12 ₹ 208.86   ₹ 188.12      
IRR @ 10% & 15% 149% 149% 149% 149%        

 

I have done manual appraisal using formulas and used EXCEL ones and all tally! I somehow believe that Gearing wont be necessary if someone can get their FCFF & FCFE projections correct! Thats an another issue at hand for me right now. We'll find out soon!!

Txs