8 Apr 2022

113

WACC and Corporate Investment Decisions

Format: APA

Academic level: University

Paper type: Essay (Any Type)

Words: 469

Pages: 2

Downloads: 0

Weighted average cost of capital is the rate a firm is expected to pay on a regular basis to all its lenders/security holders to enable it successfully finance its assets and general operations. The WACC is also referred to as the cost of capital of a firm. The weighted average cost of capital is composed of various long-term debts such as common stocks, preferred stock, bonds among others. Weighted average cost of capital is therefore computed by adding the weight of debt and equity financing (Baker & Wurgler, 2015). Therefore, weighted average cost of capital is calculated as follows:

Weighted average cost of capital (WACC) = [E/V*Ke] + [D/V * Kd *(1- TC)

Where:

Ke= cost of equity

Kd = cost of debt

TC = corporation tax rate

E = market value of company equity

D = market value of company debt

Therefore, using dividend discount model, the Wilson Corporation case-weighted average cost of capital for each scenario will be computed as follows (Baker & Wurgler, 2015).

It’s time to jumpstart your paper!

Delegate your assignment to our experts and they will do the rest.

Get custom essay

WACC scenario 1

WACC = [E/V*Ke] + [D/V * Kd *(1- TC)

1. Calculation of cost of debt

Weight of common stock (Kd) = 0.40

Yield of debt financing D/V) = 6%

Cost of debt financing after taxation (1-TC) = 6% (1-0.35) 

Therefore, cost of debt = 0.6 *4 * (1- 0.35) = 1.56%

2. Calculation of cost of equity

Weight of equity = 0.60

Using dividend growth model, cost of equity (Ke) = [D1/P0] +g

Ke = [$2.5/50] + 0.60 = 65%

Therefore, Weighted average cost of capital (WACC) = 1.56 % + 65% = 66.56 %

WACC scenario 2

1. Calculation of cost of debt

Weight of common stock (Kd) = 0.6

Yield of debt financing D/V) = 6%

Cost of debt financing after taxation (1-TC) = 6% (1-0.35) 

Therefore, cost of debt = 0.6 *6 * (1- 0.35) = 2.34 %

2. Calculation of cost of equity

Weight of equity = 0.40

Using dividend growth model, cost of equity (Ke) = [D1/P0] +g

Ke = [$2.5/50] + 0.04 = 9%

Therefore, Weighted average cost of capital (WACC) = 2.34% + 9% = 11.34 %

The CEO of Wilson Corporation statement concerning increasing the long-term debt and lowering the equity in its financing plan will result in a lower weighted average cost of capital is correct. In this case, increasing the percentage of debt in the capital structure results into a corresponding decrease in the company WACC with a large margin. As Covas & Den Haa (2012) states, raising the debt level in the company capital structure has a benefit of reducing the taxable profit due to the increased interest expense which in turn will reduce the taxable income. 

Therefore, I would advise the CEO of Wilson corporation not to increase the long-term debt because it may have adverse effects on the company image. Increasing the debt load will cause the debt lenders to grow nervous about the company financial position regarding the ability of the company to pay its financial responsibilities (Covas & Den Haa, 2012). Further, increasing the debt load will cause the expense interest to increase, and this will cause the investors to be nervous as this result into lower EPS and lower stock prices (Baker & Wurgler, 2015). Therefore, the issue of additional debt load may have a serious effect on the investors since in the case the company goes bankrupt, they will be held liable to contribute and pay for the debt of the firm. The CEO of Wilson Corporation should therefore not consider increasing the debt level despite it causing a reduced WACC.

References

Baker, M., & Wurgler, J. (2015). Do strict capital requirements raise the cost of capital? Bank regulation, capital structure, and the low-risk anomaly. The American Economic Review , 105 (5), 315-320.

Covas, F., & Den Haan, W. J. (2012). The role of debt and equity finance over the business cycle. The Economic Journal , 122 (565), 1262-1286.

Illustration
Cite this page

Select style:

Reference

StudyBounty. (2023, September 15). WACC and Corporate Investment Decisions.
https://studybounty.com/wacc-and-corporate-investment-decisions-essay

illustration

Related essays

We post free essay examples for college on a regular basis. Stay in the know!

Texas Roadhouse: The Best Steakhouse in Town

Running Head: TEXAS ROADHOUSE 1 Texas Roadhouse Prospective analysis is often used to determine specific challenges within systems used in operating different organizations. Thereafter, the leadership of that...

Words: 282

Pages: 1

Views: 94

The Benefits of an Accounting Analysis Strategy

Running head: AT & T FINANCE ANALLYSIS 1 AT & T Financial Analysis Accounting Analysis strategy and Disclosure Quality Accounting strategy is brought about by management flexibility where they can use...

Words: 1458

Pages: 6

Views: 82

Employee Benefits: Fringe Benefits

_De Minimis Fringe Benefits _ _Why are De Minimis Fringe Benefits excluded under Internal Revenue Code section 132(a)(4)? _ De minimis fringe benefits are excluded under Internal Revenue Code section 132(a)(4)...

Words: 1748

Pages: 8

Views: 197

Standard Costs and Variance Analysis

As the business firms embark on production, the stakeholders have to plan the cost of offering the services sufficiently. Therefore, firms have to come up with a standard cost and cumulatively a budget, which they...

Words: 1103

Pages: 4

Views: 180

The Best Boat Marinas in the United Kingdom

I. Analyzing Information Needs The types of information that Molly Mackenzie Boat Marina requires in its business operations and decision making include basic customer information, information about the rates,...

Words: 627

Pages: 4

Views: 98

Spies v. United States: The Supreme Court's Landmark Ruling on Espionage

This is a case which dealt with the issue of income tax evasion. The case determined that for income tax evasion to be found to have transpired, one must willfully disregard their duty to pay tax and engage in ways...

Words: 277

Pages: 1

Views: 121

illustration

Running out of time?

Entrust your assignment to proficient writers and receive TOP-quality paper before the deadline is over.

Illustration