What to do about excess cash As we saw in class nowadays there are plenty of corporations whose cash balances exceed their debt due. The question that naturally arises, is what implications do cash balances have for the WACC calculation. In answering this question, first we need to distinguish between cash used for operations and excess cash. The cash used for operations exist in a firm in order to support its daily transactions, like paying bills, employees, change in the tills etc. That means even an unlevered firm needs cash in order to produce cash flows. Excess cash on the other hand is not necessary for the operations of the firm. From a taxation point of view, both categories of cash yield interest rate which is part of taxable corporate income. However the interest income that corresponds to the cash used for operations is a necessary byproduct of the firm’s daily operational activities. As such, this interest income is already included in the cash flows of the unlevered firm in the WACC calculation. Instead the interest income of the excess cash needs to be accounted for in the tax shield calculations. More precisely, that interest income represents a negative tax shield. Let’s redo the derivation of WACC, assuming now that the firm has K of excess cash, which is invested in risk-free marketable securities. ¯ Given perpetual expected operating cash flows,C the value of the operating firm is: VU = ¯ C(1 − τ ) r∗

The value of the levered firm is ¯ ¯ C(1 − τ ) τ rD DL τ rf K C(1 − τ ) VL = + − +K = + τ (DL − K) + K r∗ rD rf r∗ The WACC is found by equating VL = ¯ C(1 − τ ) +K r ˆ

Solve for r: ˆ r = r∗ (1 − τ ˆ In addition, notice that:

DL − K ) VL − K

r= ˆ

¯ ¯ (C − rD DL + rD DL − rf K + rf K)(1 − τ ) C(1 − τ ) = VL − K VL − K

=

1 VL − K

¯ (C − rD DL + rf K)(1 − τ ) rf K rD DL rE + (1 − τ )rD − (1 − τ )rf rE rD rf 1

=

E D K rE + (1 − τ )rD −