Focus on Value: A Corporate and Investor Guide to Wealth Creation (Frank J. Fabozzi Series) by James L. Grant;James A. Abate

Author:James L. Grant;James A. Abate [James L. Grant;James A. Abate]
Language: eng
Format: epub
Published: 2008-09-04T22:23:00+00:00

Impact of Change in WACC on Wealth Creation

We can also assess the impact of a change in the cost of capital on wealth creation as measured by a change in wacc on net present value (NPV). In this context, Exhibit 3 shows the sensitivity of enterprise value and NPV to changes in the cost of capital. The exhibit is interesting in several respects. First, it shows that enterprise value and NPV are inversely related to changes in the cost of capital. When wacc rises from 10% to 11% the firm's wealth (NPV) falls by 9.09%. Conversely, if wacc were to fall by 100 basis points - from 10% to 9% then the firm's NPV would rise by about 11%. Exhibit 3 shows even greater wealth effects if the cost of capital were to change by a larger amount. For example, when the cost of capital declines by 200 basis points then the firm's NPV would rise by some 25%.

Exhibit 3 also shows that the absolute percentage change in a company's wealth is dependent on whether the cost of capital rises or falls. As noted above, when the cost of capital declines from 10% to 8%, the firm's NPV rises by 25%. However, if watt were to rise by 200 basis points - from 10% to 12% then the firm's wealth would decline by about 17%. At the extremes, the exhibit shows that if the cost of capital were to fall from 10% to 6% - a 400 basis point decline then NPV would rise by 67%, while the firm's wealth would decline by 29% for a comparative basis point rise in cost of invested capital. Although major changes in watt on a scale of 400 to 500 basis points per year seem highly unlikely for the U.S. economy, such dispersions in capital costs have occurred in the international economy.

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