Federal Reserve

Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect each component of the weighted average cost of capital (WACC). What mistakes are commonly made when estimating the WACC, and how do these mistakes arise?

Sample Solution

Various internal and external factors can change the Weighted Average Cost of Capital (WACC) for a company over time. One such external factor is the fluctuation of interest rates. The weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources. It includes common stock, preferred stock, bonds, and other debt. WACC is calculated by multiplying the cost of each capital source by its weight. Then, the weighted products are added together to determine the WACC value. The Fed has an enormous influence over short-term interest rates and WACC through the fed funds rate. As the Fed makes adjustments to interest rates, it causes changes in the risk-free rate, the theoretical rate of return for an investment that has no risk of financial loss. When the Fed raises interest rates, the risk-free rate immediately increases. If the risk-free interest rate was 2% and the default premium for the firm’s debt was 1%, then the interest rate used to calculate the firm’s WACC was 3%. If the Fed raises rates to 2.5% and the firm’s default premium remains 1%, the interest rate used for the WACC would rise to 3.5%.

According to Lizardo (2008), other inhibiting factors to the emergence of a unified definition are results of some of the already existing definitions of the concept proffered by authors in the field. Lizardo asserted that the extant definitions fall within the ambience of vagueness or over specificity; place salience on some terrorism elements or the various groups that execute acts of terror (p. 91). Considering the broad frame of violent groups that employ this tactic, arriving at a definition would be challenging. For Grob-Frizgibbon (2005), some of the definitions are too inclusive (p. 235), while neglecting the vast applicability of the strategy as well as the distinctions between the groups that adopt the approach. According to the author, the all-embracing nature of the definition of terrorism, does not account for the differences in state – and sub-state terrorism; as well as the distinctions between the objectives of the diverse categories of sub-state terrorism (national, revolutionary, reactionary and religious terrorisms) (p. 236).

The border and membership (BM) and stretching and travelling (ST) problems of the terrorism concept as expounded by Weinberg, Pedahzur and Hirsch-Hoefler (2004, p. 778-779) to a large extent sum up the challenges that may have contributed to the lack of a generally accepted definition. Regarding the BM, the authors highlighted the difficulties in distinguishing terrorism from other forms of political violence, such as insurgencies, guerrilla warfare, and civil wars. Terrorism also encounters literal and analytical STs. While literal STs are a product of the author’s geographical or psychological distance from the terrorist act, which ultimately determines what event is tagged a terrorist act, or an uprising; analytical STPs occur as a result of over generalisation of the concept. Collier and Mahon described it as follows:

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