Weighted Average Cost Of Capital Coursework Example

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Weighted Average Cost of Capital
During decision making concerning investment, it is very important and useful to understand the weighted average cost of capital. It is a key financial tool for companies and investors. It helps the investors to either invest or continue with their project. The weighted average cost of capital is utilized by financial analysts to determine the net present value a company may earn. The investors also use the weighted average cost of capital to determine the value of the company and to know the future cash flow. They do these by taking the weighted average cost of capital and divide by the number of shareholders equity and finds the companies per share value. The companies per share value enable them to invest wisely (lecturer’s last name).
Calculation of the Company’s weighted average cost of capital using the dividend discount model
Weighted average cost of capital= Weight of debt * Cost of debt * Weight of equity * Cost of equity (lecturer’s last name).
Calculating the Cost of equity capital using the Dividend Discount Model
Cost of equity capital= (Expected dividend per share/Price per share of stock)
= (2.50/50) + 0.04
= 0.05 +0.04
= 0.09 or 9%
The cost of debt= 6 * (1-0.35) = 6 * 0.65=3.90%
Weight of debt = 0.40
Weight of equity = 0.60
Weighted average cost of capital = 0.40 * 3.90 + 0.60 * 9
= 1.56 + 5.40
= 6.96%
Let us check the impact of change in the capital structure of the company
Debt is given as 60% and equity 40% in the question.

Therefore the weight of debt is 0.60 and weight of equity are 0.40.
The new weighted average cost of capital = weight of debt * cost of debt + weight of equity * cost of equity
= 0.60 * 3.90 + 0.40 * 9
= 2.34 + 3.60
= 5.94 %.
From the calculations above, weighted average cost of capital when debt is 40% and equity at 60% is 6.96%
The weighted average cost of capital when debt is at 60% and equity at 40% is 5.94%
It is clear that the average cost of capital declines from 6.96% to 5.94% with a proportionate increase of debt from 40% to 60% in the capital structure of the company.
The calculation reflects the following,
Weighted Average Cost of Capital = 1.56% + 5.4% = 6.96
Weight of debt = 6
Weight of equity = 4
Weighted Average Cost of Capital = 6 * 6% * 65 + 9%
= 2.34% + 3.6%
= 5.94%
Based on the scenario given in the question, it is clear that the weighted average cost of capital decreased from 6.96% to 5.94%. The statement of the company’s CEO that if the company can increase the amount of long-term debt so that the capital structure is 60% debt and 40% equity, the weighted average cost of capital will be lowered is a correct statement. I support the idea of a targeted weight of 60% debt and 40% towards equity. Lowering the weighted average cost of capital will make the company to have a higher net present value. It will lower the risk to adjust and it can be used to justify a project among other benefits. It will also break zero into a desirable direction (Last name of the lecturer).

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