Running head: WACC AND CORPORATE INVESTMENT DECISIONS 1
Scenario
Wilson Corporation (not real) has a targeted capital structure of 40% long-term debt and 60% common stock. The debt is yielding 6% and the corporate tax rate is 35%. The common stock is trading at $50 per share and next year's dividend is $2.50 per share that is growing by 4% per year.
The Company's Weighted Average Cost of Capital
Lopatta, Kaspereit, and Tideman (2018) explain the method of calculating the cost of equity capital by Dividend Discount Model;
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Cost of Debt
Weighted Average Cost of Capital
Possible Impact of the Change in the Capital Structure
New Weighted Average Cost of Capital
Conclusion
Capital is the most important measure of a company's market value, and the pace of its change reflects the effectiveness of doing business. The main goal of capital management is the formation of such a size and capital structure that allows to fully meet the company's need for the resources needed to solve strategic tasks. The cost of capital is a relative indicator characterizing the “price” of attracting a certain amount of financial resources from various sources, expressed as a percentage. The weighted average cost of the capital of Wilson Corporation will decrease to 5.94% from 6.96% if debt changes to 60% from 40% and equity decreases from 60% to 40%. As the higher net present value is related to the lower value of weighted average cost of capital, dropping the equity from 60% to 40%, and increasing the debt from 40% to 60% will lower the weighted average cost of the capital, so I agree with the CEO in his decision of changing the capital structure.
Wilson Corporation will have to pay only 5.94% interest rate rather than 6.96%. The weighted average cost of the capital is the measure that calculates the risks the average risk the company can face ( Graham & Harvey, 2018 ). The accuracy of its calculation depends on how carefully the values of the cost of capital of individual sources are accurately calculated. As for the dynamics of the weighted average cost of capital and its favorable value, there can be no unambiguous judgments on this matter. The only thing that is unquestionable is the assertion that, other things being equal, a decline in the weighted average cost of capital contributes to the value of the firm, which is its market value. So, changing the capital structure of the Wilson Corporation will help the CEO to break zero. It is also advisable due to the fact that the risk involved in such adjustment is low and easily controllable.
Reference
Graham, J. R., & Harvey, C. R. (2018). The Equity Risk Premium in 2018 . Available at https://ssrn.com/abstract=3151162 or http://dx.doi.org/10.2139/ssrn.3151162
Lopatta, K., Kaspereit, T., & Tideman, S. A. (2018). How Do Investors Perceive CEOs’ Style of Sustainability Reporting? The Adverse Effect on Cost of Equity Capital (July 16, 2018). Available https://ssrn.com/abstract=3214321
