Business Administration Essay on Weighted Average Cost of Capital

Published: 2021-07-01 19:39:44
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Microsoft Corporations Microsoft Corporation is an American multinational technology company that develops, produces, licenses, and supports and offers PC programming, consumer electronics and PCs and services. 6.96

Disney (Walt) Disney (Walt) is a multinational mass media and entertainment conglomerate. 7.75

Apple Inc. Apple Inc. is a multinational technology company that plans, develops, and offers consumer electronics, PC programming, and online services. 8.00

Table: Three MNCs and their WACCs.

The significance and value of Weighted Average Cost of Capital(WACC) as a monetary instrument shareholder and the company is recognized as money related examiners. It is essential for businesses to settle on their speculations they choose and examine undertakings with equivalent and exceptional risk. Focusing on more vital measurements such economic values and Net Present Values will need the weighted average cost of capital(WACC). As such, this values plays an integral role for speculators for touching base at valuations of the companies (Fernandez,2010).

It is important for organizations to make their investment decisions and assess various projects with same or dissimilar risk. WACC is commonly used in making investment decisions through evaluation of projects. For, example, let take the application of WACC in projects with the same risk whereby projects of the organization of similar risk as the current ones. As such, an organization that enters in new projects in the sector it is operating from can assume the same risk and utilize WACC as an obstacle rate to make a decision on whether it should it proceed with the project or abandon. Secondly, WACC can be used in an evaluation of project with the different risk, 1.e, those that provide two fundamental assumptions are true. In such a scenario, WACC is utilized with appropriate adjustments by considering risk and target capital structure (Fernandez,2010).

Components of WACC and How They Are Estimated

To find WACC of the company, we first need to calculate the relative weight and cost of the debt and the preferred stock. Secondly, we focus on capital structure whereby we compute the range that responsibility and value capital add to the entire venture, by using the firm's sector approximation of aggregate obligation and value to reflect the speculations on which the investors to purchase a minimum return. The third process is weighing the expense of each sort of capital by extending that every adds to the entire capital structure. This gives us the WACC, which is the normal cost of each dollar of trade used outside the company.

The first component is the debt component; the cost of debt is the rate that the firm has to pay when they borrow money from financial institutions such as banks. Debt components are estimated through calculation of yield to maturity on the company unsettled bonds. The yield to maturity on unsettled bond indicates what investors need for lending the company their money in the existing market environment (Frank & Shen, 2016).

Another component is preferred stock component whereby stockholders receive a constant but there is no maturity point. This element can be estimated by dividing the yearly dividend through the net proceeds per share of preferred stock, and this might happen after costs have been floated. Also, equity is another component of WACC. The cost of equity is the rate of returns that investors are projecting to receive after investing their money in the firms common stock. To estimate equity component, the investors should use Security Market Line Approach (SMLA). The cost of equity can also be estimated by using Capital Asset Pricing Model. In this model, equity shareholders are supposed to a minimum rate of return which is the same as the return on an investment that is risk-free apart from the replies received for bearing additional risk. The additional risk is mostly referred to as equity risk premium which proportional to the risk premium of the business sector in general times multipliers that are called beta which measures how a particular risk an individual security is regarding the aggregate business sector. Conclusively, the cost of equity has grounded the nature of the business environment and a similar orderly risk of the firm (Frank & Shen, 2016).

There is various reason why WACC differs among firms. Companies have the different asset that is financed by debt or equity, and WACC is the average cost of some of this sources of financing and taking weighted it is clear that there will be differences in what the company needs to pay for each dollar it finances. Furthermore, Certain components of the formula, similar to the cost of equity, are not reliable qualities; various gatherings might report them contrastingly for diverse reasons. All things considered, while WACC can frequently loan important knowledge into an organization, one ought to dependably utilize it alongside different measurements while figuring out if or not to put resources into an organization. Also, there are various lenders with different interest rates, and lending terms and this automatically influences WACC (Stubelj, Dolenc & Jerman, 2014).

References

Fernandez, P. (2010) WACC: Definition, Misconceptions, and Errors. Business Valuation Review, 29(4), 138-144.

Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), 300-315.

Stubelj, I., Dolenc, P., & Jerman, M. (2014). Estimating for WACC Regulated Industries on Developing Financial Markets and in Times of Market Uncertainty. Managing Global Transitions, 12(1), 55-77.

 

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