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Does this make sense?


WeiChiLoh
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I believe that the Fed has repeatedly signaled that they would start raising rates when the real economy gets moving. But the real economy is really one of the last movers in this game isnt it? It is more of a lagging indicator?

 

The corporations will appear in the earlier innings, and they have. Corporate debt issuance is at an all time high (S&P report), and quality is getting weaker (Moody's report). This drove down WACC and equities have performed tremendously. But, it seems to me that most companies are borrowing, not to fund growth CAPEX investment, but more for working capital requirements, and more importantly, financial engineering such as share repurchasing and M&A.

 

So basically, companies are getting levered, to get even more levered by buying back shares and doing minimally accretive M&A.

 

So, the WACC, especially for companies of lower credit, drops exponentially with debt load. This is especially so for lower credit companies with high cost of equity in proportion to cost of debt. They are more sensitive to changes in the capital structure.

 

So when the Fed raises rate, companies, especially those of lower quality, would suffer, as companies have became largely entrenched into debt rates. As the lower credit companies typically have weak businesses and thus slim margins of the WACC, they would suffer the most as a small rise in rates, would spur a large rise in their WACC, which erodes their margins at an even wider margin. On a market-wide level, WACC rises and the market crashes.

 

What do you guys think?

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What happens to the WACC is as the company becomes more levered the cost of equity increases to offset the cost of debt.  At the optimal capital structure level (typically based upon the historical industry average), the WACC is the lowest.  At higher debt level the cost of equity increases at a faster rate than the cost of debt declines.  As to whether increases in debt rates will increase the WACC, is dependent the assumption of increasing interest rates.  I personally do not think interest rates will go up because of huge demand from pension and retirement accounts in the developed world where most of the financial asset are.  The debt rate used in WACC calculations is the LT debt rate so it is driven more by market forces versus fed actions.

 

Packer

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One limitation of your reasoning is the underlying assumption that WACC actually changes continuously for companies. In reality, companies raise debt in discrete amounts and at specific times, and if they have raised enough sometimes a few years can go by before they need to tap the debt market again.

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Guest wellmont

even if fed were to, Gasp, raise rates all the way to 2%, that is a level that is way below what corporations and banks have historically had to deal with. we've been conned into thinking the world will end if rates go up.

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One limitation of your reasoning is the underlying assumption that WACC actually changes continuously for companies. In reality, companies raise debt in discrete amounts and at specific times, and if they have raised enough sometimes a few years can go by before they need to tap the debt market again.

Just because companies issue debt/equity at discrete intervals doesn't mean that the WACC isn't changing continuously. Debt and equity prices do change (almost) continuously. If their debt is for example trading above par they would presumably be able to issue debt at lower rates and visa versa.

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