The Weighted Average Cost of Capital (WACC)

The weighted average cost of capital is the weighting factor determined that is used to value a firm’s cash flows or to determine the value of a firm. Future projected cash flows can be discounted to obtain the present day value of a firm or company using the weighted average cost of capital computed. This can also be termed as the rate of return of a f certain investment of a firm. The capital structure of a company is usually comprised of the preference share capital, ordinary share capital/common stock and the debt aspect. (Accounting Explained, 2013) The higher the rate of return or cost of capital, the better it is for a company as it poised to make more cash flows on its investments. 

Wilson Corporation has a debt structure target of 40% debt and 60% equity represented by common stock. Taxation is set at a rate of 35% and the price per share is 50 presently. The dividends are projected to grow as follows at 4% increment per year: 

Year1: 2.5 

Year 2: 1.4*2.50= 3.5 

Year 3: 1.4*3.5= 4.9 

Year 4:1.4*4.9 = 6.86 

Thus the 4% return is what the shareholders expect on their investment which essentially is the cost of equity. 

Using the dividend discount model 

52.50=50(1+r)^n 

1.05= 1+r 

0.05=r 

5%=r 

So the cost of equity using the dividend discount model is 5% 

Weighted average cost of capital: 

Cost of equity (ke) *Equity/total value of firm (E/V)+ cost of debt(kd* debt/total value of firm(D/V)*(1-TAX ) 

(5%*60% )+ (6%*40%)*(1-35%) 

0.03+ (0.024)*(1-0.35) 

0.03+0.0156 

Wacc= 0.0456 / 4.56% 

After the capital structure changes 

Debt = 60% 

Equity = 40% 

Weighted average cost of capital: 

Cost of equity (ke) *Equity/total value of firm (E/V) + cost of debt (kd* debt/total value of firm (D/V)*(1-TAX) 

(5%*40%) + (60%*6%) (1-0.35) 

0.02 +0.036(1-0.35) 

Wacc=0.0434 / 4.34% 

The alteration of the capital structure lowers the weighted average cost of capital by 0.22 %; however this change through increasing the debt weight from 40% to 60% favors the firm as debt funding is exempt from taxation thus the firm pays less tax or makes actual tax savings .This is a good legitimate way of tax avoidance. So the move is preferable because of the tax saving against a small reduction in the rate of return /wacc. 

Reference 

Accounting Explained. (2013). Weighted Average Cost of Capital . Retrieved November 2016, from Accounting Explained website: http://accountingexplained.com/misc/corporate-finance/wacc