Purpose Of Assignments Students Should Understand Corporate

Purpose Of Assignmentstudents Should Understand Corporate Risk And Be

Students should understand corporate risk and be able to use the financial models learned in the class to evaluate and calculate a company's weighted average cost of capital and use the analysis to make company investment decisions.

About Your Signature Assignment: This assignment is designed to align with specific program student learning outcomes. It involves analyzing a company's capital structure, calculating its weighted average cost of capital (WACC), and making recommendations for investment decisions based on the analysis.

Scenario: Wilson Corporation has a targeted capital structure of 40% long-term debt and 60% equity. The debt yields 6%, and the corporate tax rate is 35%. The company's stock is trading at $50 per share, and next year's dividend is $2.50 per share, growing at 4% annually.

Your task is to prepare a minimum 700-word analysis including: calculations of Wilson Corporation's WACC using the dividend discount model; a discussion on the CEO's proposal to increase debt to 60% and decrease equity to 40%, analyzing whether this change would lower the WACC; and a recommendation for the CEO based on your analysis. Show all calculations in Microsoft Word. Your report should be formatted consistent with APA guidelines.

Paper For Above instruction

Wilson Corporation’s weighted average cost of capital (WACC) is a crucial metric for assessing the company's cost of financing and making informed investment decisions. This analysis involves calculating the current WACC based on given data, evaluating the CEO’s proposal to recalibrate the capital structure, and providing strategic recommendations grounded in financial logic.

The current capital structure of Wilson Corporation consists of 40% long-term debt and 60% equity. The cost of debt is given as 6%, and the corporate tax rate is 35%. For calculating the cost of equity, the dividend discount model (DDM) is employed, utilizing the dividend per share, growth rate, and stock price.

Using the DDM, the cost of equity (Re) is calculated as:

Re = (D1 / P0) + g

Where:

D1 = dividend next year = $2.50

P0 = current stock price = $50

g = growth rate of dividends = 4%

Substituting the values:

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

Next, the after-tax cost of debt (Rd) accounts for the tax shield:

Rd = yield on debt × (1 - tax rate) = 6% × (1 - 0.35) = 6% × 0.65 = 3.9%

Now, the current WACC is calculated as:

WACC = (E/V) × Re + (D/V) × Rd

Where:

E/V = 60% (equity portion)

D/V = 40% (debt portion)

Re = 9%

Rd = 3.9%

WACC = 0.60 × 0.09 + 0.40 × 0.039 = 0.054 + 0.0156 = 0.0696 or 6.96%

Thus, the current WACC for Wilson Corporation is approximately 6.96%.

The CEO suggests increasing leverage by shifting the capital structure to 60% debt and 40% equity, arguing that this move will lower the WACC. To evaluate this claim, we recalculate WACC under the proposed capital structure.

Using the same cost of debt and equity, the new WACC is:

WACC = 0.40 × 0.09 + 0.60 × 0.039 = 0.036 + 0.0234 = 0.0594 or 5.94%

This indicates that increasing the debt portion to 60% reduces the overall WACC from 6.96% to approximately 5.94%. The logic behind this reduction stems from the lower cost of debt compared to equity and the tax shield benefits, which make debt financing cheaper.

However, increasing leverage also heightens financial risk, potentially leading to higher costs of debt in the future and increased bankruptcy risk. Although WACC might decline initially due to tax advantages, excessive debt can jeopardize financial stability.

In advising the CEO, it is essential to balance the benefit of lowered WACC against the risks linked with higher leverage. The strategic objective should be to optimize the capital structure to minimize the weighted average cost while maintaining financial flexibility and safeguarding against insolvency risks.

Based on the analysis, my recommendation is to consider a gradual increase in leverage, carefully monitoring the firm's credit rating and debt servicing capacity. The current evidence shows that leveraging to 60% debt does lower WACC, but the company must assess whether such an increase aligns with its risk appetite and market conditions. Conservative firms should avoid excessive debt to preserve financial stability, whereas growth-oriented firms could benefit from a moderate increase in leverage.

In conclusion, Wilson Corporation's decision to alter its capital structure should be grounded in a comprehensive risk-return assessment. While higher leverage can improve valuation through lower WACC, it also elevates financial risk. A balanced approach that carefully calibrates the debt-to-equity ratio can support sustainable growth and shareholder value maximization.

References

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