Running head: WACC AND CORPORATE INVESTMENT DECISIONS 1
WACC and Corporate Investment Decisions
Introduction
Weighted average cost of capital (WACC) is defined as the process in which a company’s cost of capital is calculated where proportional weightings of each capital’s category is done. It incorporates all capital sources including long term’s debts, bonds, common stock and preferred cost. In general, a corporation’s WACC increases with increase in equity’s rate of return. An increase in WACC implies that there is a reduction in valuation thus resulting in increased risk (Zeitun & Tian 2014).
It is calculated using the formula below
WACC = (E/V) x Re + (D/V) x Rd x (1-Tc). (Farber et al. 2006)
Where,
E/V= Equity’s financing percentage.
E= equity’s market value
Re= cost of equity
D/V= debt’s financing percentage
D= debt’s market value
V= firm’s total market of financing (E+D)
Rd= cost of debt
Tc= corporate tax rate
WACC for Wilson Corporation Using Dividend Discount Model
Cost of equity = (Expected dividend per share/price per share of stock) + growth rate
= ($2.50 / $50) + 4% = .050 + 4% = 9%
Calculation of cost of debt = 6 x (1-0.35) = 6 x .065 = 3.90%
Calculation of WACC = Weight of debt x Cost of debt + Weight of equity x Cost of equity
=0.40 x 3.90 + 0.60 x 9 = 1.56 + 5.40 = 6.96%
The current WACC for Wilson corporation is 6.96%
Impact When the Debt Is Increased to 60% And Equity to Decreased to 40%
WACC = Weight of debt x Cost of debt + Weight of equity x Cost of equity
= 0.60 x 3.90 + 0.40 x 9 = 2.34 + 3.60 = 5.94%
The new WACC is 5.94%.
Based on the result, I agree with the CEO that increasing debt amount will lower the firm’s cost of capital. This is because financing of debt usually has tax advantages as compared to the financing of equity. In other words, the debt’s interest expenses tend to be tax deductible which assists in the reduction of cost of debt capital. As evidenced above, it reduces from 6.96% to 5.94%.
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Advice to The CEO
My advice to the CEO is to consider adopting an optimal capital structure that provides an ideal balance between equity and debt as well as minimizing firm’s cost of capital. The ideal structure lies in between the concepts of maximizing profits and reducing financial burdens. However, to come up with optimal structure, the CEO needs to evaluate the availability of cost of debt and equity, availability of equity capital and firm’s profitability.
Similarly, the CEO needs to manage the cash flow to identify financial and business risks. In case there is a possibility of high financial and business risk, the CEO should use equity levels that are higher in such a situation. Larger amounts of debts should be used when a business is generating adequate cash flow to maximize the returns. He/she should also consider the interest rates on debt. When interests are low, the CEO should use more debt and less equity to take the advantage of less costs hence minimizing capital expenditures (Magni, 2015). The opposite is true for higher interest rates.
Conclusion
In this scenario, it is evident that debt’s cost is quite lower than that of equity. Therefore, to obtain an optimal capital structure, the CEO should implement the option of 40% equity and 60% debt. This will assist the corporation to raise the funds needed while maintaining an optimal structure at the same time thereby resulting in lower cost of capital. Furthermore, considering financial and business risks will ensure that the company has adequate cash flow to meet both operating and capital expenditures.
References
Farber, A., Gillet, R. L., & Szafarz, A. (2006). A General Formula for the WACC.
Magni, C. A. (2015). Investment, financing and the role of ROA and WACC in value creation. European Journal of Operational Research , 244 (3), 855-866.
Zeitun, R., & Tian, G. (2014). Capital structure and corporate performance: evidence from Jordan.
