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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).
Since the capital structure is made of preferred equity, common equity, and debt, the capital structure of a...
The WACC takes the weight of each component into account and presents a cost of the new calculated capital. If the results of the WACC indicate too high of debt, or low preferred equity, the structure of the capital may need to be evaluated to bring the WACC back into line (Pareja, 2005).
Clearly, the weighted cost of capital is important to a company in terms of investor relations and overall fair market value of a company. Any alteration in WACC can drastically affect these values, creating a wide impact on a company's budget and capital structure. Ensuring a proper calculation of WACC is therefore vital to the continued financial success of a company.
References
Buckley, A. (2002). Multinational finance. Financial Times. New York: Prentice Hall.
Pareja, V., Ignacio, A, and Tham, J. A note on the weighted average cost of capital WACC. Retrieved December 1, 2006 from SSRN. Web site: http://ssrn.com/abstract=254587.
Valuatum. (2006). WACC. Retrieved December 1, 2006 from Valuatum. Web site: http://www.valuatum.com/analyst/excel_general_instructions.shtml.
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