Question

To improve EVA, the firm should simply lower its debt ratio because a lower debt ratio reduces the cost of debt and thus the WACC of the firm." True or false? Select one: a. False b. True

Answer 1

Economic Value Add (EVA) = Net Operating profit after taxes - (Total Assets - Current Liabilities) * WACC.

And WACC = Debt ratio * after tax cost of debt + Equity ratio * cost of equity

So there are 2 components in WACC, equity and debt and cost of equity, as we know is always greater than cost of debt.

Now if we reduce debt ratio, it will reduce cost of debt portion in WACC, BUT, decrease in debt ratio will lead to increase in Equity ratio, which will increase the cost of equity portion.

Example : Lets assume :

Debt ratio = 0.6

After tax cost of debt = 5%

Equity ratio = 0.4

Cost of equity = 10%

WACC = 0.6*5 + 0.4*10 = 7%

New ratios

Debt ratio = 0.4

After tax cost of debt = 5%

Equity ratio = 0.6

Cost of equity = 10%

WACC = 0.4*5 + 0.6*10 = 8%

So WACC increase by decreasing the debt ratio. So answer is FALSE