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).
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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.
