The weighted average cost of Capital (WACC) is the rate of return that the organization must attain to satisfy the needs of its investors ( Frank and Shen, 2016) . Typically, the investors of the organization can be grouped into security holders and the lenders. The security holders own shares in the organization and will accept a given return on their investment. Similarly, the lenders will also expect profit on their investment. Therefore, a company should ensure that the overall return on investment exceeds the weighted average cost of capital to maintain the investors in the organization. If the return on investment is less than the WACC, then the company is making a loss and thus losing value for every dollar invested.
The structure of the weighted average cost of capital is directly affected by the management decision. The management may choose to have more security holders and fewer lenders. However, when the organization has many stockholders, decision making becomes complex as the input of the owners need to be considered. On the other hand, the lenders may not have direct influence over the organization’s operations but will expect higher returns for their investments. Lending organizations also have substantial financial resources that are needed by companies to undertake significant investment projects. Sole contribution of funds from the equity members may not be sufficient in running the viable projects of the firms. The management of an organization may thus choose to balance between the interest of the investors and those of the security holders when designing the WACC structure.
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The management makes the critical decision regarding the amount of funds to borrow from the lenders as well as the available stocks for sale. If the organization acquires more funds from the lenders and reduces the number of stockholders, then the WACC is bound to increase. However, the firm will have more discretion over its internal operations. If the management decides to have more security holders in the firm with few investors, the WACC may be lower, but decision making will be complicated. The stockholders have high influence over the organization as they bear the risks and profits of the firm. If the organization makes losses, then the stockholders are bound to lose. However, if the organization makes profit, the security holders gain. On the other hand, the lenders expect their interests on the investment irrespective of the returns which are made by the organization.
WACC is extensively used in making capital budgeting decisions. Through capital budgeting, an organization uses both discounted and non-discounted techniques to determine the viability of the projects. The returns which are related to various project ideas are compared with the weighted average cost of capital to determine the feasibility of the projects. The different techniques of capital budgeting include the net present value, internal rate of return and the payback period ( Almazan, Chen, and Titman, 2017) . If the gains from the capital budgeting analysis indicate that the return for a project exceeds the WACC, then the investment is considered. However, if the project results in lower yields compared to the WACC, then the idea is rejected.
The first mistake that managers must avoid when making capital budgeting decision includes underestimating the time value for money. A dollar today is worth more than a dollar tomorrow ( Almazan, Chen, and Titman, 2017) . Therefore, managers must use discounted techniques in determining the returns which are related to a project. The second mistake includes disregarding the value of the rate of capital depreciation. The rate of capital depreciation must be taken into account while determining the future cash flows of a project. The sunk cost of a used asset is lower than the actual cost of the item. Thirdly, managers should avoid relying on one technique of project appraisal. A given project might indicate a positive Net Present Value even though the payback period is too long. In such cases, the manager must determine whether the investors are willing to wait for the returns. Similarly, the future investment risks must also be taken into account. The fourth mistake that managers make includes neglecting the future uncertainties of a project. An investment idea may have high projected cash flows but is bound to extreme political and economic risks.
If the company has a WACC of 15 percent and it has numerous project ideas to be implemented, then project appraisal techniques may be used to filter the unfeasible investments. The cost of capital in the analysis will be deemed to be the same as WACC. The organization will then calculate the internal rate of return for the various projects. The investment idea with a return of higher than 15 percent should be considered for investment.
References
Almazan, A., Chen, Z., & Titman, S. (2017). Firm Investment and Stakeholder Choices: A Top ‐ Down Theory of Capital Budgeting. The Journal of Finance , 72 (5), 2179-2228.
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics , 119 (2), 300-315.
