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With Subsidized Debt How do we Adjust the WACC?

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  • Joseph Tham
  • Ignacio Velez-Pareja Velez-Pareja

Abstract

In the standard Weighted Average Cost of Capital (WACC) applied to the free cash flow (FCF), we assume that the cost of debt is the market, unsubsidized rate. With debt at the market rate and perfect capital markets, debt only creates value in the presence of taxes through the tax shield. In some cases, the firm may be able to obtain a loan at a rate that is below the market rate. With subsidized debt and no taxes, there would be a benefit to debt financing, and the unlevered and levered values of the cash flows would be unequal. How would we adjust the WACC to take account of the subsidized debt? And how would we adjust the expression for the required return to levered equity? In this paper, using a single period example we present the adjustments to the WACC with subsidized debt. We demonstrate the analysis for both the WACC applied to the FCF and the WACC applied to the capital cash flow (CCF). For simplicity, we assume that there are no taxes. The analysis can be extended easily to multiple periods in the presence of taxes.

Suggested Citation

  • Joseph Tham & Ignacio Velez-Pareja Velez-Pareja, 2005. "With Subsidized Debt How do we Adjust the WACC?," Proyecciones Financieras y Valoración 3783, Master Consultores.
    • Handle: RePEc:col:000463:003783
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    Cited by:

    1. Ignacio Vélez-Pareja & Joseph Tham & Viviana Fernández, 2005. "Adjustment of the WACC with Subsidized Debt in the Presence of Corporate Taxes: The N-Period Case," Economic Analysis Working Papers (2002-2010). Atlantic Review of Economics (2011-2016), Colexio de Economistas de A Coruña, Spain and Fundación Una Galicia Moderna, vol. 4, pages 1-19, October.

    More about this item

    Keywords

    WACC;

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis

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