The following analysis of Wilson Corporation’s equity cost and Weighted Average Cost of Capital (WACC) is aimed at determining whether the CEO of the company made a reasonable suggestion to increase the long-term debt and balance debt by 60% and equity by 40%.
In the beginning, it is important to mention that in order to determine WACC, the calculations should include the total market value of the company along with the corporate tax rate and Wilson Corporation’s capital structure. In the analysis, the Dividend Discount Model will be used. DDM is a procedure used for valuing (calculating) a stock price through using the predicted dividends and discounting them to the present value. The formula for calculating the value of the stock is the following:
Stock value = Dividend per share / (Discount rate – Dividend growth rate) (“Dividend discount model – DDM”, n.d.).
The weighted average cost of capital is calculated by the following formula:
WACC = E / V * (re) + D / V * (rd) * (1-t).
re is the cost of equity;
rd is the cost of debt;
E is the firm’s equity market value;
D is the firm’s debt market value;
E/V is the percentage of financing for equity;
D/V is the percentage of financing for debt;
t – corporate tax rate (“Weighted average cost of capital,” 2016).
Wilson Corporation’s cost of equity is the following:
Cost of equity = Next year’s dividends per share / current market value of stock * Dividends’ growth rate = (2.50*50) + 0.04 = 0.05 + 0.04 = 5% + 4% = 9%
WACC = 40% * 6% * (1-35%) + (60% * 9%) = 2.4% * 65% + 5.4% = 6.96%
If to take into account the calculations made above, it can be concluded that the increase of long-term debt can have a positive result regarding the growth of Wilson Corporation. The 9% cost of equity plays a determining role in the valuation of the firm’s stocks because investors expect their investments in equity increase by at least 9% as shown by the calculations. Therefore, cost of equity can be used to determine what the discount rate should be used in order to identify the fair value of the investment’s equity. Because the fair value of investments equity falls between the cost of equity of 9% and debt capital (6%), it makes sense that the CEO of Wilson Corporation suggested to increase the long-term debt and balance debt by 60% and equity by 40%. Such actions associated with debt and equity are likely to decrease the corporation’s WACC to become closer to the cost of debt.
Recommendations to the CEO of Wilson Corporation
First, it is important to discuss in detail what long-term debt represents. According to Kennon (2017), long-term debt on the balance sheet of a company refers to the amount of money that is required to be paid back a period longer than twelve months. Long-term debt can include mortgages on land or corporate buildings, corporate bonds issued with the help of investment banks, and so on (Kennon, 2017). When making a decision on whether to increase or decrease long-term debt, it is imperative to take into consideration that WACC will decrease only in the case if all other variables remain constant due to the adjustments in the capital structure of the organization. Moreover, increased debts lead to higher financial risks (Kennon, 2017). For example, if Wilson Corporation increase long-term debt by 60% and it becomes higher than the capital structure of the majority of similar companies, then the organization will risk being exposed to a higher volume of pressure. Subsequently, the increased risks may lead to equity investors and lenders ask for higher returns and thus influencing the growth of Weighted Average Cost of Capital.
Given the repercussions mentioned above, it is still recommended that the CEO of Wilson Corporation proceeds with increasing the long-term debt to reach the capital structure of 60% debt and 40%. As one of the options of increasing long-term debt, issuing of bonds can be recommended. A bond will play the role of a loan between Wilson Corporation and investors. The investor will give the company a set amount of money in return for periodic interest payments at set time intervals. It is recommended to issue bonds instead of choosing other methods of raising money because the interest rates involved in borrowing from a bank are much higher, which can subsequently lead to the increase of corporate risks (Smith, 2016). Moreover, issuing stocks is even riskier for business since it means giving proportional ownership of a company to investors in return for money. While the money paid for stocks does not have to be repaid by a company, the main downside in this situation is that the issuance of stocks has a dramatic effect on ownership as well as how a company is operated. Therefore, issuing bonds is the best option for Wilson Corporation given the increase of long-term debt in the capital structure.
References
Dividend discount model – DDM. (n.d.).
Kennon, J. (2017). Long-term debt and the debt-to-equity ratio on the balance sheet.
Smith, L. (2016). Why companies issue bonds.