Debt equity mix in corporate finance

Finance

WACC, or the weighted average cost of capital, is a vital calculation for any corporation. While understanding how WACC is calculated is important, it is also important to understand why such a calculation is needed, and the impact of the calculation on budgeting and structure. WACC can be considered the formula used to determine if specific investment strategies, projects, or purchases are worthwhile in terms of cost analysis (Valuatum, 2006). Corporations often calculate this cost to create a value for shareholders in terms of a return on invested capital that is above the cost of such capital. The WACC is expressed as a percentage, and it is assumed that any investment, purchase, or project undertaken should give returns equal or higher than the WACC (Valuatum, 2006). Thus, if a company is operating with a 12% WACC, all investments should yield returns at or higher than 12%.

WACC is important for a number of reasons. In particular, this cost of capital is a key component when calculating the DCF fair value, or the discounted cash flow value. Small changes in the WACC, such as may occur with a small, inopportune investment, can significantly alter the DCF. Since the DCF is really a representative value of the fair value of a company, and is generally compared with competitors, any adverse change to the DCF can have drastic effects of investments and share prices (Valuatum, 2006). Alone, the WACC is generally not used to determine investment decisions. However, when used to do a reality check on fair value with the DCF, such a calculation is vital in a fair value economy.

Additionally, the WACC can be a sign of problems to come. Many investors look to the WACC calculation to determine in a company is in financial hardship, or is managing their assets effectively. As the Financial Times reported on Dec 30, 2002, "The inability of companies to make enough money to cover the cost of the money they borrowed is the most obvious red flag that a crisis is going to happen" (Buckley, 2002).

In addition, the WACC has a great impact on the budgeting and structure of a company. Fist, the WACC depends on the capital budget. A company calculates the retained earnings breakpoint, or the capital raised beyond which new stock must be issued, and compares it to the capital budget. A capital budget smaller than the breakpoint would use the lower cost retained earnings and therefore a lower WACC. A capital budget higher than the breakpoint would use a higher cost of equity, and would result in a higher WACC (Pareja, 2005).

Further, since the WACC is used to calculate the risk of investment and purchasing, a company must choose a combination of projects, investments, and purchases that yield the highest returns when adjusted for the cost of capital. Thus, when budgeting expenditures for any given time frame, the WACC becomes an important component for calculating what investments and other projects to undertake. Further, since it relies somewhat on capital budget, any given area of a corporation may need to calculate differently depending on their own capital budget fluctuations, resulting in an altering company structure in relation to WACC (Pareja, 2005).