Unlike personal finances, managing an organization's finances is quite complicated and challenging. A successful business will always generate a weighted average cost of capital (WACC) that reflects a combination of funding sources, including equity and debt. WACC is fundamental in understanding whether investing in a project or company is viable, and the stock can register growth within the specified time (Berry et al., 2014). In essence, investors use WACC to determine the capital an organization must generate to produce returns to the stakeholders. An increase in the WACC value means the company operates under high debt and equity financing (Frank & Shen, 2016). On the other hand, a decline in the WACC value means the company is performing well and does not need external funding. WACC uses the following formula:
WACC = [(E/V) * Re] + [(D/V) * Rd * (1-Tc)]
Where:
E = Market value of the business
V = Total market value of the business (E+D)
Re = Cost of Equity
D = Market value of the business debt
Rd = Cost of debt
Tc = Tax Rate
Taking the scenario of two companies with the following financial statements:
|
Company 1 |
Company 2 |
|
| Outstanding shares | 1,200,000 | 4,750,000 |
| Market price of shares | $31 | $47 |
| Market capitalization | $37,200,000 | $223.250.000 |
| Market value of debt | 415,000,000 | $46,500,000 |
| Cost of equity | 17% | 14% |
| Cost of debt | 4.7% | 6.9% |
| Tax rate | 35% | 355 |
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Using the above formula to calculate the WACC for both companies, Company 1 yields a WACC of 0.96, while Company 2 yields 0.80. While the values are quite close to one another, Company 2 is better positioned to expand than Company 1 due to its high market capitalization and lower WACC. As earlier noted, a lower WACC translates to better financial performances with the company needing little assistance from external funding sources.
Reply to Classmate
Dear Audra Harris, I acknowledge your efforts in posting a discussion on the WACC task. Indeed, I agree that higher WACC means the company is operating on high debts and equity. However, while you introduced us to WACC and what it represents in financial management, you failed to create a hypothetical WACC as mandated in the discussion post. Regardless, I challenge you to look at other posts and analyze how they managed to create a hypothetical WACC and determined if the company should expand or not.
References
Berry, S. G., Betterton, C. E., & Karagiannidis, I. (2014). Understanding weighted average cost of capital: A pedagogical application. Journal of Financial Education , 115-136. https://www.researchgate.net/profile/Iordanis_Karagiannidis2/publication/289530651_Understanding_Weighted_Average_Cost_of_Capital_A_Pedagogical_Application/links/56c092d708ae44da37fbf6fc.pdf
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics , 119 (2), 300-315. https://doi.org/10.1016/j.jfineco.2015.09.001
