Wilson Corporation's capital structure is intended to be 60% ordinary stock and 40% long-term debt. The debt has a 6% yield, while the corporation tax rate is 35%. The common stock is trading at $50 per share, and the dividend for next year is $2.50 per share, increasing by 4% every year. For this project, I will use the dividend discount model to evaluate and compute the company's WACC. The preceding is carried out by displaying computations of the cost of equity capital and the WACC. Besides, I will discuss and expound if I agree or disagree with the statement of the CEO that if the company raises long-term debt and equity, it will lower its WACC. In this paper, I will demonstrate and confirm my ability to use financial models that I have learned in class to compute and evaluate the WACC and utilize it in the analysis in making excellent corporate investment decisions.
Weighted Average Cost of Capital (WACC) and Corporate Investment Decisions
When corporations make decisions about investment, understanding the WACC is beneficial and essential. It is a financial tool for companies and shareholders to help gauge if they should proceed with a project or invest. When calculating meaningful metrics like what would be the net present value a corporation may receive or earn, it is pertinent for their financial analysts to utilize WACC. When investing in any business, investors will invest time prior to investing any amount of money (Pogue, 2010). They will try to find out the value of that company and their future cash flows by using WACC and dividing the result by the number shareholders equity. The outcome is the companies per share value; therefore, they can decide if they should invest or not.
Calculations
The initial step is the computation of the cost of equity capital (Dividend Discount Model) which is obtained by dividing expected dividend per share by price per share of the common stock and adding growth rate. That is;
Cost of equity capital = Growth rate + (Expected dividend per share/ Price per share of stock)
= 0.04 + (2.50/50) = 0.04 + 0.05 = 0.09 that is nine percent.
Cost of debt = 6 * (1-0.35) = 6 * 0.65 = 3.90 %
Next is the calculation of WACC.
WACC= Cost of debt * Weight of debt + Equity cost * Weight of equity
= 3.90 * 0.40 + 9 * 0.60 = 1.56 + 5.40 = 6.96 %.
As given in the question, the impact of the change in the capital structure is given as 60 percent debt and 40 percent equity.
Therefore, the New WACC will be calculated as below.
WACC= Cost of debt * Weight of debt + Equity cost * Weight of equity
= 3.90 * 0.60 + 9 * 0.40 = 2.34 + 3.60 = 5.94 %.
Analysis
From the calculations presented above, it can be seen that WACC when the debt is 40%, and equity is 60% is computed to be 6.96%. On the other hand, when the debt is 60%, and investment is 40% the WACC is calculated to be 5.94%. With an increase in the proportion of debt from 40% to 60% in the capital structure of the business, the weighted average cost of capital decreased or reduced from 6.96% to 5.94%.
Based on this scenario, we can see the WACC has decreased from 6.96% to 5.94%. The company's CEO has stated if the company increases the amount of long-term debt to the capital structure will be 60% debt and 40% equity, this will lower its WACC. CEO has made a correct statement. I agree with the CEO and would advise him that they should go for the targeted weight of 60% towards debt and 40% towards equity. Having a lower weighted average cost of capital, you will have a higher net present value (Pogue, 2010). It is a lower risk to adjust, and it is used to justify a project since it breaks zero in the right direction.
Conclusion
WACC is an important metric used by corporations for different purposes. Indubitably, the WACC is essentially the average risk that a company might face. This paper computed the WACC of Wilson Corporation by use of the dividend discount model. In this essay, I demonstrated my capability of utilizing financial models that I have learned in class to compute and evaluate the WACC and use it in the analysis in making excellent corporate investment decisions. Based on the calculations and analysis above, I agree with the CEO of that raising the long-term debt lowers the WACC. In this case, the going for a targeted weight of 40% towards equity and 60% towards debt will reduce the WACC, and hence the corporation will realize a higher net present value.
References
Pogue, M. (2010). Corporate Investment Decisions: Principles and Practice. doi:10.4128/9781606490655
