For the practice problem 23rd from the curriculum, the answer says Repurchasing shares or paying a dividend would increase the debt weight, which would reduce the WACC. How does this happen? I mean if you repurchase shares, it would increase debt only is you use debt financing. What if you use your excess cash? How will that reduce WACC? And, how does paying a dividend increase debt?? Also, does repurchasing shares decrease equity by the repurchased amount?
Share repurchases using cash will (in general) have the following impact on the balance sheet and WACC:
- reduce cash by the repurchase amount
- reduce equity be the repurchase amount
- increase debt / equity ratio (as equity is reduced) and also debt weight (= debt / (debt + equity))
- lower WACC
Share repurchases using debt will (in general) have the following impact on the balance sheet and WACC:
- increase debt by the repurchase amount
- reduce equity by the repurchase amount
- increase debt / equity ratio and also debt weight (= debt / (debt + equity))
- lower WACC
Paying a dividend using cash will have the following impact on the balance sheet and WACC:
- reduce cash by the dividend amount
- reduce equity by the dividend amount
- increase debt / equity ratio (equity is lower now) and also debt weight (= debt / (debt + equity))
- lower WACC
Note that in all these cases WACC will only be lowered as long as your costs for financial distress do not get out of hand (e.g. at high D/E ratios doing any of the above may actually increase your WACC).
Okay thank you
Very good answers. Thank you