Apa 700 Word Analysis With 3 Cited References Wilson Corpora

Apa 700 Word Analysis With 3 Cited Referenceswilson Corporation Not

Apa 700 word analysis with 3 cited references. Wilson Corporation (not real) has a targeted capital structure of 40% long term debt and 60% common stock. The debt is yielding 6% and the corporate tax rate is 35%. The common stock is trading at $50 per share and next year's dividend is $2.50 per share that is growing by 4% per year. Calculate the company's weighted average cost of capital. Use the dividend discount model. Show calculations in Microsoft ® Word. The company's CEO has stated if the company increases the amount of long term debt so the capital structure will be 60% debt and 40% equity, this will lower its WACC. Explain and defend why you agree or disagree. Report how would you advise the CEO.

Paper For Above instruction

Introduction

The weighted average cost of capital (WACC) is a critical financial metric that reflects the average rate a company is expected to pay to finance its assets through both debt and equity. WACC influences investment decisions, capital budgeting, and overall valuation of a firm. In this analysis, we examine Wilson Corporation’s current capital structure and evaluate the proposal to increase leverage, assessing whether such a change would lower its WACC and the implications of such a strategy.

Calculation of WACC

Wilson Corporation’s current targeted capital structure consists of 40% debt and 60% equity. The cost of debt is given as 6%, while the corporate tax rate is 35%, which affects the after-tax cost of debt. For equity, the dividend discount model (DDM) will be employed to estimate the cost of equity, considering the expected dividend growth.

Cost of Debt

The after-tax cost of debt (Kd) incorporates the tax shield benefits provided by interest expense. It is calculated as:

\[ Kd = \text{Yield on debt} \times (1 - \text{Tax rate}) \]

\[ Kd = 6\% \times (1 - 0.35) = 6\% \times 0.65 = 3.9\% \]

Cost of Equity Using the Dividend Discount Model

The DDM estimates the required return on equity based on current dividends, stock price, and dividend growth rate:

\[ Ke = \frac{D1}{P} + g \]

Where:

- \( D1 \) = Next year's dividend = $2.50

- \( P \) = Current stock price = $50

- \( g \) = Growth rate of dividends = 4%

Calculating the cost of equity:

\[ Ke = \frac{2.50}{50} + 0.04 = 0.05 + 0.04 = 0.09 \text{ or } 9\% \]

Calculating WACC

Using the weighted average formula:

\[ \text{WACC} = (E/V) \times Ke + (D/V) \times Kd \]

Where:

- \( E/V = 60\% \)

- \( D/V = 40\% \)

- \( Ke = 9\% \)

- \( Kd = 3.9\% \)

Substituting the values:

\[ \text{WACC} = 0.60 \times 9\% + 0.40 \times 3.9\% = 0.054 + 0.0156 = 0.0696 \text{ or } 6.96\% \]

Therefore, Wilson Corporation’s current WACC is approximately 6.96%.

Impact of Increasing Debt

The CEO suggests increasing long-term debt to 60%, reducing equity to 40%. Let’s analyze whether this change would lower the WACC.

Recalculating with the new capital structure:

\[ E/V = 40\% \]

\[ D/V = 60\% \]

Using the same costs:

\[ \text{WACC} = 0.40 \times 9\% + 0.60 \times 3.9\% = 0.036 + 0.0234 = 0.0594 \text{ or } 5.94\% \]

This indicates that increasing debt funding can reduce the WACC from approximately 6.96% to 5.94%, supporting the assertion that higher leverage could lower the company's overall cost of capital.

However, it is essential to consider the associated risks. Elevated leverage amplifies financial risk, potentially increasing the cost of debt over time and negatively impacting creditworthiness and flexibility. Also, the assumption that costs remain constant might not hold if debt levels rise substantially.

Defense of the Strategy

Based on the calculations, increasing the proportion of debt appears to lower the WACC initially, aligned with the Modigliani-Miller theorem with corporate taxes, which suggests that debt financing offers tax shields and reduces overall costs (Modigliani & Miller, 1963). Therefore, from a purely financial perspective, the proposal could be advantageous, provided the firm manages increased financial risk effectively.

Recommendations to the CEO

While the quantitative analysis suggests that higher leverage reduces WACC, strategic considerations such as the company’s debt capacity, industry standards, and economic environment must guide decisions. Excessive leverage might lead to higher bankruptcy risk and diminish shareholder value if not carefully managed (Frank & Goyal, 2009). I advise the CEO to consider a balanced approach, possibly increasing debt modestly while maintaining financial flexibility and avoiding over-leverage. A comprehensive risk assessment and stress testing should accompany any shift in the capital structure.

Conclusion

In conclusion, increasing Wilson Corporation’s leverage from 40% to 60% debt could lower its WACC, making the firm more attractive for investments and potentially increasing shareholder value. Nonetheless, these benefits must be balanced against heightened financial risk, emphasizing the importance of prudent capital structure management. The optimal capital structure is one that minimizes the WACC without compromising the company’s operational and financial stability.

References

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• Modigliani, F., & Miller, M. H. (1963). Corporate Income Taxes and the Cost of Capital: A Correction. American Economic Review, 53(3), 433–443.
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