WACC and Corporate Investment Decisions

16 Oct No Comments

WACC and Corporate Investment Decisions

Fin/370

Introduction to the Wilson Corporation

Wilson Corporation 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 CEO has stated if the company increases the amount of long term debt so the capital structure will be 60% debt and 40% equity, this will lower its WACC. Explain and defend why you agree or disagree. Report how would you advise the CEO. The purpose of this analysis of the Wilson Corporation’s cost of equity and their WACC is to determine if their CEO is correct in saying that the best interest of the company is to increase their long-term debt and balance their debt at 60% and their equity at 40%

Calculation of cost of equity capital (Dividend Discount Model)

According to our text book the weighted average cost of capital, or WACC, is the cost of capital for the firm as a whole and it can be interpreted as the required return on the overall firm. For the calculations used in determining the WACC of the Wilsons Corporation I will include the total market value, the corporate tax rate, and the capital structure. I would also like to point out that the WACC and the cost of equity are being calculated use the Dividend Discount Model. The dividend Discount Model is used to find the value of a stock price by taking the predicted dividends and discounting them back to the PV. If the value given when using the DDM is higher than the current value of the shares then the stock is considered to be undervalued. The DDM has many different variables and it won’t work for companies that don’t pay out dividends. The primary advantage of the dividend growth model approach is that it’s easy to both understand and use.

Calculations

The formula is: WACC = (E/V) x Re + (D/V) x Rd x (1-Tc).

Calculation of cost of debt = 6 x (1-0.35) = 6 x .065 = 3.90%

  • Cost of equity = (Expected dividend per share / price per share of stock) + growth rate
  • = ($2.50 / $50 ) + 4% = .050 + 4% = 9%

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%

Impact of the chance in the capital structure-

Debt = 60%

Equity = 40%

New 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%

WACC (Debt = 40%, Equity = 60%)6.96%

WACC (Debt = 60%, Equity = 40%)5.94%

Analysis

After calculating the numbers I can agree with the CEO and his statement that if the company increases the amount of long term debt making the capital structure equal to 60% debt and 40% equity, that the WACC would be lower. Knowing that the Weighted Average Cost of Capital is the risk that a firm could face with the knowledge that as the capital structure changes, such as an increase in long term debt with this example, and it will lower the weighted average cost of capital. This analysis of the Wilson Corporation shows that there would be a positive outcome to increases their long-term debt. A key component in the valuation of stock is the cost of equity. This is because an investor will expect an investment to grow by the cost of the equity.

Conclusion

In conclsion I would advicse the CEO of Wilson Corporation to increase their amount of long term dept so the capital structure would equal 60% debt and 40% equity. If the Wilson Corporation is considering taking on additional investors they may run into the problem of high debt to equity ratio scaring away possible investors even though the CEO’s recommendation would be good for company growth. If Wilson Corporation does proceed to increase the amount of long term debt now they should avoid any other increases for a while in order to keep their capital structure at a stable growth rate.

References

Ross, S. A., Westerfield, R., & Jordan, B. D. (2015). Fundamentals of CorporateFinance. 11th ed. New York, NY: McGraw-Hill/Irwin

Weighted Average Cost Of Capital – WACC. (2017). Retrieved fromhttp://www.investopedia.com/terms/w/wacc.asp




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