When calculating WACC, what if a firm has no long-term debt, but has current liabilities (Working Capital line items only)
How do we go about computing the D/E ratios? Or is the WACC basically the cost of equity..
Thanks.
Weighted Average Cost of Capital with No Long Term Debt
If a company has no long term debt - the WACC of a company will be its cost of equity - or the capital asset pricing model. This is because the WACC equation is the cost of debt * percent of debt in the capital structure * (1 - tax rate) + cost of equity * percent of equity in the capital structure. In this instance - the amount of debt would be 0.00% so WACC will just be the equity component which is the capital asset pricing model.
CAPM is calcuated as the risk free rate + Beta * (equity risk premium).
The equity risk premium is calcuated as the expected return on the market - the risk free rate. However, the the expected return on the market is notoriously difficult to calculate - therefore many bankers refer to the equity risk premium provided by Aswath Damodaran, a professor at NYU Stern.
Should We Include Working Capital Items?
No - working capital items should not be inlcuded as they are not interest bearing securities and therefore it is inappropriate to consider them as a "cost of capital."
Debt to Equity
Debt to Equity ratio is calcuated as total liabilities / total equity.
This would mean that working capital liabilities would be included in this number.
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