The weighted average cost of capital describes the cost of acquiring capital of a company in which all the sources of financing are weighted proportionately.
Tina Memsic
The article I analyzed for this discussion is titled Capital Allocation at HCA (2019). To better understand the title of this article, I need to define weighted average cost and the cost of capital allocation and explain how it compares to this class textbook.
The weighted average cost of capital describes the cost of acquiring capital of a company in which all the sources of financing are weighted proportionately. Notably, the sources of financing of a firm include preferred stock, common stock, and bonds or debts (Norman, 2014). An increase in WACC implies that the risk has increased while the valuation has decreased. As such, a surge in beta and the rate of a return causes the WACC to increase. The WACC is evaluated as;
E represents the equity component of financing, D represents the value of debt, and V represents the total funding in the company’s capital structure given by E+D. The cost of equity defines the rate of return that the company investors expect to be compensated for taking the risk in putting their money in the company operations. It is evaluated using the CAPM model in which the beta of the firm is multiplied by the market premium return plus the risk-free rate. The risk-free rate is normally the rate of return available on treasury bills or government bonds. At the same time, beta measures the volatility of the company stock relative to the market movements. In evaluating the WACC, unlevered beta is used since the effect of debt is already addressed by the debt component of the WACC (Norman, 2014).
Assuming that the stock’s beta is 1.2, the interest rate on 10-year treasury bills is 5%, and the market portfolio return is 8%, the expected rate of return can be given as; 5%+1.2*(8%-5%) =8.60%.
The company’s cost of debt describes the interest rate for which the company acquired the debt or the rate at which the debtors will be repaid their interest. In contrast, the tax rate represents the corporate tax imposed by the government on the corporations.
In conclusion, this article equities to our class textbook. Both explain how companies use various sources of funding to finances their business operations and expansion projects. These sources of funding comprise of equity (stock) and debts or bonds. The funding from these sources is acquired at a cost depending on their size and nature. The WACC reveals the average cost of acquiring funding in which each source of financing is proportionally weighted based on the company’s capital structure. With this information, the WACC tells us the return that lenders and shareholders expect to receive to provide capital to a company. For example, if lenders require a 10% return and shareholders require 20%, then the company’s WACC is 15%. Again, this information is useful in determining whether a company is building or shedding value. Its return on invested capital should be higher than its WACC.
The WACC can be thought of in two ways:
Investors Perspective: The return that funds could earn in an alternative investment of similar risk or
Firms Perspective: Average after-tax costs of new funds available to the firm.
The rule of thumb is if the firm can generate higher risk-adjusted returns on projects (than investors can earn elsewhere), the managers should invest in those projects as the NPV of this project would be positive.
References
Block, S. B., Hirt, G. A., & Danielsen, B. R. (2019). Foundations of financial management (17th ed.). McGraw-Hill Higher Education.
Kester, W. C., & McComb, E. R. (2019). Capital Allocation at HCA. Harvard Business Publishing Education, https://hbsp.harvard.edu/product/218039-PDF-ENG.
Norman, G. (2014). Weighted Average Cost of Capital. In Dictionary of Industrial Organization. Edward Elgar Publishing Limited.
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