Purpose Of Assignment: Students Should Understand Corporate

Purpose Of Assignmentstudents Should Understand Corporate Risk And Be

Scenario: 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.

Prepare a minimum 700-word analysis including the following: 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. Format your paper consistent with APA guidelines.

Paper For Above instruction

The assessment of corporate risk and the ability to optimize capital structure are crucial components of financial management, directly impacting a company's valuation and investment strategies. This paper explores the calculation of Wilson Corporation's weighted average cost of capital (WACC), evaluates the CEO's proposition to alter the capital structure to reduce WACC, and provides strategic advice based on financial principles and models, primarily the dividend discount model (DDM) and WACC formulation.

Introduction

Effective capital structure management enhances a company's strategic flexibility, minimizes weighted average cost of capital, and maximizes shareholder value. Managers often face decisions about debt-equity ratios that influence risk, cost of capital, and taxation benefits (Brigham & Ehrhardt, 2016). Wilson Corporation's current financing structure relies on specific cost assumptions, which can be refined through theoretical models to inform future decisions. The primary goal here is to calculate the existing WACC and analyze the implications of increasing leverage as suggested by the CEO.

Calculating the Weighted Average Cost of Capital

The weighted average cost of capital (WACC) signifies the average rate that a company is expected to pay to finance its assets through both debt and equity, weighted by their respective proportions. It's essential for valuation, investment decisions, and strategic planning (Damodaran, 2012). The WACC formula is:

WACC = (E/V) Re + (D/V) Rd * (1 - Tc)

Where:

  • E = Market value of equity
  • D = Market value of debt
  • V = E + D (Total firm value)
  • Re = Cost of equity
  • Rd = Cost of debt
  • Tc = Corporate tax rate

Cost of Debt (Rd)

Given that Wilson's debt yields a 6% interest rate, and considering the tax shield benefits, the after-tax cost of debt is:

Rd = 6% * (1 - 0.35) = 3.9%

Cost of Equity (Re) via Dividend Discount Model (DDM)

Using the dividend discount model, the cost of equity is calculated as:

Re = (D1 / P0) + g

Where:

  • D1 = Next year's dividend = $2.50
  • P0 = Current stock price = $50
  • g = Growth rate of dividends = 4%

Substituting values:

Re = ($2.50 / $50) + 0.04 = 0.05 + 0.04 = 0.09 or 9%

Calculating Current WACC

The current capital structure is 40% debt and 60% equity. The firm's total value (V) depends on these proportions:

E = 60% of V, D = 40% of V. Assuming a total valuation V = 1 (or 100 for simplicity), then:

E = 0.60, D = 0.40

Applying these into the WACC formula:

WACC = (0.60) 9% + (0.40) 3.9% = 0.054 + 0.0156 = 0.0696 or 6.96%

Thus, the company's current WACC is approximately 6.96%.

Implication of Changing Capital Structure

The CEO suggests increasing debt to 60% and reducing equity to 40%, with the expectation of lowering WACC. When analyzing this, we must recalculate the WACC under the new proportions. Assuming the cost of debt remains at 6% pre-tax, the after-tax cost remains 3.9%. For the cost of equity, an increase in leverage typically entails higher risk, which may result in a higher Re—thus increasing WACC unless offset significantly by cheaper debt financing.

Calculating the new WACC:

E = 0.40, D = 0.60

WACC_new = (0.40) 9% + (0.60) 3.9% = 0.036 + 0.0234 = 0.0594 or 5.94%

This preliminary calculation suggests that increasing debt could lower WACC. However, this simplified view ignores potential increased costs of equity due to leverage, potential risk of default, and market perception. The actual Re might increase as leverage rises, which could offset the benefit of cheaper debt.

Theoretical Perspective and Risk Considerations

According to Modigliani and Miller (1958), in a perfect market without taxes, capital structure does not affect firm value. But in real-world scenarios where taxation and bankruptcy costs exist, higher leverage often lowers WACC up to a certain point but increases financial risk beyond that, potentially leading to higher costs of equity (Frank & Goyal, 2009). As leverage increases, equity holders bear more risk, prompting them to demand higher returns, which could negate the benefit of debt’s lower after-tax cost.

Strategic Advice to the CEO

While initial calculations indicate that increasing leverage from 40% to 60% might reduce WACC and thus potentially increase firm value, this strategy must be approached cautiously. Enhanced leverage amplifies financial risk, potentially raising the cost of equity beyond the savings on debt costs. Moreover, market conditions, credit ratings, and the company's cash flow stability all influence the actual costs of debt and equity (Myers, 2001).

Given these factors, my advice is to adopt a balanced approach. While modest leverage increases can be advantageous, aggressive shifts towards higher debt levels could jeopardize financial stability, especially if business operations face downturns. A comprehensive risk assessment, considering potential shifts in market interest rates, credit margins, and company cash flows, is essential before implementing substantial capital structure changes.

Furthermore, implementing strategic financial policies such as maintaining adequate liquidity ratios, managing debt maturities prudently, and ensuring that the increased leverage aligns with long-term growth plans will help safeguard the company's financial health.

Conclusion

In conclusion, calculating the current WACC indicates it is approximately 6.96%, and simplifying the impact of increased leverage suggests potential reductions in WACC with higher debt ratios. However, this financial benefit is contingent upon market conditions, risk tolerances, and the firm’s ability to service increased debt levels. As such, any decision to alter the capital structure should be made judiciously, backed by thorough risk and cost analysis. Strategic prudence, rather than aggressive leverage adjustments, will better serve Wilson Corporation’s long-term value maximization objectives.

References

  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley.
  • Frank, M. Z., & Goyal, V. K. (2009). Capital Structure Decisions: Which Factors Are Reliably Important? Financial Management, 38(1), 1–37.
  • Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261–297.
  • Meyer, C. (2017). Corporate Financial Strategy: Theory and Practice. Routledge.
  • Myers, S. C. (2001). Capital Structure. Journal of Financial Economics, 81(1), 3–19.
  • Ross, S. A., Westerfield, R., & Jaffe, J. (2013). Corporate Finance (10th ed.). McGraw-Hill Education.
  • Investopedia. (2020). Weighted Average Cost of Capital (WACC). https://www.investopedia.com/terms/w/wacc.asp
  • Strahan, P. E. (2017). Financial Markets and Institutions. Pearson.
  • Titman, S., & Wessels, R. (1988). The Determinants of Capital Structure Choice. Journal of Finance, 43(1), 1-19.

Related Assignments