The Weighted Average Cost of Capital FIN
The Weighted Average Cost . The Weighted Average Cost of Capital (WACC) of a company is the average interest rate; a firm should give to finance its growth, working capital, and assets. Besides, the WACC is also the minimum average return rate a firm must earn from its current assets in order to gratify the company owners or shareholders, investors or creditors. Therefore, WACC is the proportionate least after-tax mandatory rate of return that companies must gain for all company securities such as preferred stock-holders, debt-holders, and common stock-holder. WACC is determined by finding out the cost of elements of a company’s capital and then multiplying it with the percentage proportion of that element in total capital and then sum up the proportionate cost of elements. Thus, WACC is a weighted average of equity cost, preference shares, and debt, and the weights are the percentage of capital which companies’ source from each element respectively in market values (Hicks 2017, p.60).
The Weighted Average Cost. Cost for Coogly’s Preferred Stock
The preferred stock cost to the firm is effectively the price the firm pays in return for the proceeds it realizes from selling and issuing the stock. The cost of preferred stock is the amount that Coogly pays out yearly divided by the lump sum it gets from stock issues.
Cost of preferred stock = dividend/ price of a share
The Coogly’s cost of the preferred stock = 4/82 = 4.88%
However, with flotation costs, the cost of preferred stock changes due to the costs of flotation.
The Coogly’s cost of the preferred stock = 4/ (82-6) = 5.26%
The Weighted Average Cost . Advantages of the Cost of Preferred Stock
- It is strong to appeal to cautious investors and investors who are risk-averse.
- It provides flexibility in capital structure. Preferred stock is redeemable by the company in case of overcapitalization and addition of capital amounts can be collected by issuing extra shares.
- It ensures dividends on equity share should increase in order to issue preferred shares.
- Can be changed into common stock after a fixed period.
- The firm is free of repaying anxiety, and the company shareholders cannot be compelled to bankruptcy (Hicks 2017, p.61).
The Weighted Average Cost. Disadvantages of the Cost of Preferred Stock
- Preferred stock causes a permanent burden to companies with fluctuating incomes
- Preference shareholders have no voting rights
- Preferred stock is fixed and has no right on surplus profit
- They are redeemable during a depression
- Preferred stock has a high cost because in general, the dividend rate is more than the rate of interest on the bonds. This makes the cost of preferred stock to substantially be more than the debt financing costs (Lin 2017, p. 4).
The Cost of Common Stock or Issuing New Equity
The costs of common stocks are used in the capital structure in the calculation of WACC. The formula for calculating the cost of common stock is given as;
The Cost of Common Stock = Dividend/Price*(1- Flotation Cost) + Growth Rate
= 3.8/ (50-9) + 7%
= 9.27% + 7%
The Weighted Average Cost. Advantages of the Cost of Common Stock or Issuing New Equity
- Fixed costs are unchanged by new equity capital
- Dividend issued to investors of equity can be deferred and the income aimed at business opportunities and other specifications of operations (Lin 2017, p. 6).
- It is a free collateral financing.
- It provides long-term financing for companies.
- It is a free, convenient financing
Disadvantages of the Cost of Common Stock or Issuing New Equity
- It does not guarantee profits or business growth for equity investors
- It involves legal restrictions in using equity financing and the financing transaction structure.
- The financial returns’ distribution is legally restricted to using equity financing.
The Cost of Debt Financing
Cost of debt is the effective rate that a firm pays on its present debt. The cost of debt is one component of the capital structure of a company (Means 2017, p.20). The formula for determining the cost of debt is given as follows;
Cost of debt = the Coupon rate on Bond (1- tax rate)
= 6% (1-40%)
The WACC of Coogly
The weighted average cost of capital for Coogly = cost of equity + cost of debt +cost of preferred stock. Given that the company maintains 30% debt, 10% preferred stock and 60% new common stock and cost of preferred stock is 5.26%, the cost of debt is 3.6%, and cost of common stock is 16.27%.
The WACC = (10%* 5.26%) + (30%* 3.6%) + (60%* 16.27%)
The Weighted Average Cost. Advantages and Disadvantages of WACC
The weighted average cost of capital is an essential tool for companies because it is the benchmark that can be applied to determine various projects in the process of capital budgeting. It is simple and easy to compute in order to evaluate projects. Besides, WACC saves time in evaluating projects and provides timely decision-making process. However, the shortcomings of WACC are drawn from its applicability assumptions. It is hard to keep the capital structure and unrealistic assumptions of no adjustment in the risk profile of the new project. Besides, WACC avoids important sources of capital in its calculations which may significantly influence the outcomes of the answers (Means 2017, p.33).
Companies should, therefore, effectively evaluate the WACC of its capital structure in order to ensure accurate capital financing. This will improve shareholders’ confidence and provide the long-term financial ability of the company.
Hicks, J.R., 2017. From ‘Value and Capital.’ In Bond Duration and Immunization (pp. 57-61). Routledge.
Lin, N., 2017. Building a network theory of social capital. In Social capital (pp. 3-28). Routledge.
Means, G., 2017. The modern corporation and private property. Routledge, pp. 1-45.