Capital structure entails combining debt and equity in the specific promotion for the significance of raising finances necessary for investment purposes or company operations. The equity proportion of the capital structure may entail preferred stock, common equity, and retained earnings. Debt financing comprises both long-term and short-term debts, while common stock is a security that divides the company’s capital into equal value sold to the investors. The investor can earn divided once declared or the capital gain when the company’s share appreciates on the security market. The shareholders who own the preferred share are granted preferential treatment, such as receiving dividends, whether the company makes a profit (Yildirim et al., 2018). For the Apix Company, the capital structure entails a combination of common equity and debt of 60% and 40%, respectively.
The Weighted Average of Capital for Apix Limited is calculated as:
- WACC = (Cost of Equity x Weight of Equity) + (Cost of Debt x Weight of Debt) (1 – Tax Rate)
- Cost of Equity = Risk Free Rate + Beta*(Market Return – Risk Free Rate) = 2%+1.5*(11%-2%) = 15.50%
- Weight = 60%, Cost of debt = 8%, Weight = 40%, Tax Rate = 35%
- (15.5%*60%) + (8%*40%) *(1-35%) = 11.38%
The WACC is the required rate of return of the company’s cost to raise the capital needed for its investments. The WACC can be used to access projects’ profitability or economic viability using different tools such as Internal Rate of Return, Net Present Value, Discounted Payback Period, and Profitability Index. A positive net present value implies the project is economically viable when the WACC is used as the discounting rate. WACC determines the payback time in today’s dollars by discounting future cash flows to their present value (Pavel, 2018). To assess the project’s viability, upper management can use the discounted cash flow method to check if the maximum permissible payback period can be satisfied using current dollars. In contrast, profitability can be evaluated by the Internal Rate of Return. The project is expected to generate a positive cash flow if the internal rate of return is higher than the WACC. Before investing, businesses need to use WACC as a discount rate baseline to assess the viability of potential initiatives.
Businesses need access to funding to keep running or to start a new project. As a result, they can maintain or adjust their capital structure by issuing, repurchasing stock, or redeeming their existing short- and long-term debt. WACC is affected by a shift in capital structure because each component weight of the debt or equity helps determine the weighted average cost of equity for the company. The firm would need additional capital to engage in a new project, affecting its original capital structure and, in turn, the company’s WACC. Apix’s current debt-to-equity ratio resulted in a weighted average cost of capital (WACC) of 11.38 percent. The weighted average cost of capital would be very different if the company raised cash by issuing stock or debt and changed its capital structure to 70% equity and 30% debt to finance a new project. In this case, misleading results can be recorded if the company’s target WACC is used. Instead, I suggest using the WACC of the specific investment or the project.
When Apex needs to purchase new equipment today to improve customer service efficiency, additional financing is needed by either taking debt or issuing stocks. The company would incur costs for debt financing and expected return on equity for the common stock. When more capital is needed, it comes at a price known as the marginal cost of capital. Accordingly, the marginal cost of capital is defined as the cost incurred by a company to raise an additional dollar of cash for financing new projects, investments, or operations (Andrianesis & Caramanis, 2020). Apix is currently funded by 40% debt and 60% equity; thus, any costs associated with securing further finance would be the marginal cost of capital.
References
Andrianesis, P., & Caramanis, M. (2020). Distribution network marginal costs: Enhanced AC OPF including transformer degradation. IEEE Transactions on Smart Grid, 11(5), 3910-3920. Web.
Pavel, Z. (2018). The impact of cash flows and weighted average cost of capital to enterprise value in the oil and gas sector. Journal of Reviews on Global Economics, 7, 138-145. Web.
Yildirim, R., Masih, M., & Bacha, O. I. (2018). Determinants of capital structure: Evidence from Shari’ah compliant and non-compliant firms. Pacific-Basin Finance Journal, 51, 198-219. Web.