I have learned from the thread "Cost of debt, taxes and WACC" 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:
- the new project is exactly as risky as the rest of the firm's projects, and
- 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.