Corporate Risk and WACC

Part 1

Calculating Wilson Corporation Weighted Average Cost of Capital (WACC)

            Long term Debt = 40%

Common stock   (equity) = 60%

Debt yield = 6%

Corporate tax = 35%

Common stock price = $50 per share

Next year’s dividend = $2.50

Annual growth = 4%

WACC = Weight of debt (before-tax cost of debt) (1-T) + weight of stock (Cost of stock)

Calculate cost of equity

            Cost of equity = r = (D₁/Po) + g

From the information given D1 = $2.50, Po = $50, g = 4%

            Cost of equity = ($2.50/$50) + 4%

                                    r = 0.05 + 4%

                                    r = 4.05%

Calculating cost of debt = debt yield (1 – T)

                                    = 6% * (1 – 0.35)

                                    = 6% * 0.65

                                    = 0.039 = 3.9%

Considering the weights given; equity = 60% and debt = 40%, WACC is given as

WACC = 3.9%* 40% + 4.05% * 60%

            = 0.0156 + 0.0243

            = 0.0399 = 3.99%

Therefore, the weighted average cost of capital = 3.99%

Part 2

If debt is increased to 60% and equity reduced to 40%

New WACC would be = 3.9% x 60% + 4.05% x 40%

                        WACC = 3.96%

From the above analysis, it is clear that when the debt is increased to 60% and equity reduced to 40% the weighted average cost of capital reduces to 3.96%. One aspect that can be identified from this analysis is that the debt financing has tax advantages when compared to equity financing. Ideally, the interest expense of debt tends to be tax deductible indicating that this helps reduce the Cost of Capital (WACC) as seen in the above analysis. The cost of capital reduces from 3.99% to 3.96% upon reduction of equity and increasing of equity of Wilson Corporation.

Recommendation to the CEO

Given the above analysis, the CEO should consider adopting an optimal capital structure which offers a ideal balance between equity and debt, as well as, minimizing the cost of capital of the frim. Ideally, the optimal capital structure lies between minimizing the financial burden and maximizing the profits of the firm. In doing so, the CEO should consider the cost of equity, availability of equity capital, the profitability and the cost of debt. Additionally, the CEO has to consider financial and business risks which face the business. Financial and business risks arise when the business does not generate enough cash flows to meet its financial obligations when they fall due (DeAngelo, and Masulis, 2010). If it happens that the business has high business and financial risks, the CEO may consider increasing the equity level as oppose to debt to minimize its financial obligations (expenses resulting from interest expenses). On the other hand, if the business is generating adequate cash flows the CEO may consider using large amounts of debt to allow maximizing the returns of the firm (DeAngelo, and Masulis, 2010).

When the interest rate on debt is high, the CEO should advise the financial managers to consider raising the firm’s capital using more equity which may include trading more shares. High interests on debt indicate that the firm spends more of its cash in paying interest on debt. Consequently, this would reduce the profitability of the firm. Conversely, when the interest rates on debts are low, financial manager may consider increasing debt level and reducing its equity to take advantage of the low cost of debt (DeAngelo, and Masulis, 2010). Such considerations would help the firm minimize capital expenses and maximize profits realizes by the firm hence financial growth. Taking such financial considerations would ensure that the firm has sufficient cash flows to meet its operating expenditures, as well as, growing without straining its resources.

There are advantages of utilizing more debt than equity ranging from tax deductions to financial, and capital benefits. For instance, more debt implicates tax deductions which help the firm reduce its cost of capital. Interest expenses on loans are deducted from the earnings before tax – indicating that the amount of income subjected to taxation would be less. The higher the interest expense the lesser the tax liability (DeAngelo, and Masulis, 2010). On the other hand, debt helps the company to raise finances which match its capital requirements and complete its projects. Through this approach, the company cannot be forced to sell its assets to finance its projects (DeAngelo, and Masulis, 2010). Conversely, financing the company via equity reduces the cost level of the firm which indicates increased profitability to the firm. In conclusion, the cost of debt is lower than that of equity and the CEO has to consider taking the 40% equity and 60% debt and enjoy the financial benefits associated with high debt level.  

References

DeAngelo, H., & Masulis, R. W. (2010). Optimal capital structure. Journal of financial      economics, 8(1), 3-29.