WACC What role does the cost of capital play in the overall financial decision making of the firm’s top managers?
There are different sources of funds that could be accessed by a company to manage its various business activities. These may include funds obtained from either operating activities or non-operating activities. The combination of funds obtained from these sources forms the capital structure of the company. All these sources of funds have a cost to the company that is collectively referred to as the Weighted Average Cost of Capital (WACC). In other words, WACC is the cost of capital of a company. Therefore, it could be stated that WACC is an important factor that affects the capital choice of companies (Brigham & Ehrhardt, 2016).
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The companies require funds to reinvest in their business or invest in new projects that could create value for their shareholders. WACC affects the decisions of a finance manager as the cost of capital is one of the most significant determinants of the outcome of the capital decision (Brigham & Ehrhardt, 2016). The future cash flows of the business have a time value that could be determined by discounting cash flows by using the company’s WACC. Therefore, it could be stated that WACC is the minimum expected return that investors require on funds that they put in the business.
If the company does not generate the minimum return, then it may not be feasible for the business to continue. Therefore, companies always seek ways to minimize their cost of capital that would assist them in achieving the shortest payback period for their investment in the business or new projects (Baker & Martin, 2011). If WACC is high, then it will take more effort and a longer period for the company to generate a positive return on investment. However, it is not always possible to lower WACC as companies have limited access to funds. The finance managers need to assess the availability of funds and carefully plan business activities to generate a profit (Brigham & Ehrhardt, 2016).
DEBT VS EQUITY: Why do you think debt offerings are more common than equity offerings and typically much larger as well?
The capital structure of a company consists of debt and equity. The choice between debt and equity depends on the current state of the business and market conditions. There is no single theory that could explain the capital structure of companies in the same industry (Baker & Martin, 2011). One of the possible explanations of capital structure choice is the cost associated with debt and equity.
The companies tend to have more debt than equity because the cost of borrowing is less than raising equity. I am of the view that raising equity through IPOs or the issuance of authorized shares in the capital market is very expensive. Moreover, the process of raising fresh equity through the capital market is challenging as it requires strict regulatory compliance for protecting shareholders’ rights and corporate reporting (Baker & Martin, 2011). The companies often lack the understanding and expertise to manage the IPO.
The companies can approach various debt providers and negotiate terms that suit their current business requirements. There is more flexibility for them to acquire funds from external sources. The companies can easily borrow funds from banks or investment companies at easy terms with low cost. Moreover, the tax shield theory of capital structure states that companies borrow more because the interest expense is deductible from their operating income. They prefer to borrow at a low cost to avoid high tax payable on income (Baker & Martin, 2011).
Baker, H. K., & Martin, G. S. (2011). Capital structure and corporate financing decisions: theory, evidence, and practice. Hoboken, NJ: John Wiley & Sons.
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Brigham, E. F., & Ehrhardt, M. C. (2016). Financial management: Theory and practice. Boston, MA: Cengage Learning.