<p>I have learned from the thread <a href="https://economics.stackexchange.com/questions/53076">&quot;Cost of debt, taxes and WACC&quot;</a> that WACC is <strong>forward looking</strong> in that it disregards the interest rate on debt already taken by the firm but rather use debt's current yield to maturity (YTM) as an indication of how expensive it would be to take on a marginally small amount of <em>additional</em> debt today.<sup>1</sup> I can accept the feature &quot;forward looking&quot; as part of the definition of WACC. However, I wonder how relevant it is in some circumstances.</p>
<p><strong>Example 1:</strong> Suppose a firm is 100% debt financed<sup>2</sup>, and the debt consists of a borrowing facility with a fixed cost <span class="math-container">$c$</span> and interest rate <span class="math-container">$r$</span> where the firm can borrow as much as it likes up to an upper limit <span class="math-container">$U$</span> and only pays interest on the amount that has actually been borrowed. Suppose the firm has only borrowed a small amount so far and is thus well below <span class="math-container">$U$</span>. The firm considers a new project that can be taken up, and the financing needed for it would be obtained from the same borrowing facility without exceeding <span class="math-container">$U$</span>. Then the actual cost of capital for this project is literally <span class="math-container">$r$</span> (if we ignore taxes for a moment). <strong>I wonder</strong> what the advantages of using forward-looking WACC are in such a case? And if it should make any difference, we can consider two subcases:</p>
<ol>
<li>the new project is exactly as risky as the rest of the firm's projects, and</li>
<li>the new project is not exactly as risky as the rest of the firm's projects.</li>
</ol>
<p><strong>Example 2:</strong> Suppose a firm is 100% debt financed, and the debt consists of a single, long-term loan with interest rate <span class="math-container">$r$</span>. Suppose some of this loan is sitting in the firm's account unused, and the firm considers a project that can be taken up without the need for any additional financing. Then the actual cost of capital for this project is literally zero. Again, <strong>I wonder</strong> what the advantages of using forward-looking WACC are in such a case? And again, if it should make any difference, we can consider two subcases as above.</p>
<p><sup>1</sup>I think it has to be a marginally small amount. Otherwise, if a large amount of new debt were to be taken, it would also make the debt more risky by watering down the share of equity in the total capital. Please correct me if I am wrong.</p>
<p><sup>2</sup>This is unrealistic, but I hope we can tolerate that in this example.</p>

CC BY-SA 4.0
2022-10-15T15:23:33.947Z
The actual cost is not zero. It's the opportunity cost as well. You could do something else with that money.
Alex
CC BY-SA 4.0
2022-10-19T11:10:00.927Z
Another related question: https://economics.stackexchange.com/questions/53181
Richard Hardy
CC BY-SA 4.0
2022-11-01T15:13:58.807Z
@Alex, might you be interested in a bounty? Expiring soon...
Richard Hardy
CC BY-SA 4.0
2022-11-01T16:30:24.050Z
@user253751, in example 1, yes. In example 2, probably no, as the required return on such debt might well have changed since the time the firm took out the loan. So in example 2, if the firm repaid the loan and wanted to take out another loan like it, the interest rate on that might be different from $r$.
Richard Hardy
<debt><corporate-finance><cost><capital>
WACC: forward looking vs. backward looking
Richard Hardy
# WACC: forward looking vs. backward looking

(Asked by: username_0 on 2022-10-15)

I have learned from the thread ["Cost of debt, taxes and WACC"](https://economics.stackexchange.com/questions/53076) that WACC is **forward looking** in that it disregards the interest rate on debt already taken by the firm but rather use debt's current yield to maturity (YTM) as an indication of how expensive it would be to take on a marginally small amount of *additional* debt today.1 I can accept the feature "forward looking" as part of the definition of WACC. However, I wonder how relevant it is in some circumstances.

**Example 1:** Suppose a firm is 100% debt financed2, and the debt consists of a borrowing facility with a fixed cost $c$ and interest rate $r$ where the firm can borrow as much as it likes up to an upper limit $U$ and only pays interest on the amount that has actually been borrowed. Suppose the firm has only borrowed a small amount so far and is thus well below $U$. The firm considers a new project that can be taken up, and the financing needed for it would be obtained from the same borrowing facility without exceeding $U$. Then the actual cost of capital for this project is literally $r$ (if we ignore taxes for a moment). **I wonder** what the advantages of using forward-looking WACC are in such a case? And if it should make any difference, we can consider two subcases:

1. the new project is exactly as risky as the rest of the firm's projects, and
2. the new project is not exactly as risky as the rest of the firm's projects.

**Example 2:** Suppose a firm is 100% debt financed, and the debt consists of a single, long-term loan with interest rate $r$. Suppose some of this loan is sitting in the firm's account unused, and the firm considers a project that can be taken up without the need for any additional financing. Then the actual cost of capital for this project is literally zero. Again, **I wonder** what the advantages of using forward-looking WACC are in such a case? And again, if it should make any difference, we can consider two subcases as above.

1I think it has to be a marginally small amount. Otherwise, if a large amount of new debt were to be taken, it would also make the debt more risky by watering down the share of equity in the total capital. Please correct me if I am wrong.

2This is unrealistic, but I hope we can tolerate that in this example.

**Tags:** debt, corporate-finance, cost, capital
> **Comments:**
> **username_1**: The actual cost is not zero. It's the opportunity cost as well. You could do something else with that money.  
> **username_0**: Another related question: https://economics.stackexchange.com/questions/53181  
> **username_0**: @Alex, might you be interested in a bounty? Expiring soon...  
> **username_0**: @user253751, in example 1, yes. In example 2, probably no, as the required return on such debt might well have changed since the time the firm took out the loan. So in example 2, if the firm repaid the loan and wanted to take out another loan like it, the interest rate on that might be different from $r$.  

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## 0 answers

