Understanding Weighted Average Cost Of Capital (WACC) And Its Components

What is Weighted Average Cost of Capital (WACC)?

Discuss about the AVEO Company for Journal of Financial Management.

Weighted average cost of capital (WACC) depicts a company’s financial position in (miles & Ezzell, 2012)consideration to its ability to finance innovative projects or other payments by raising cash from external sources. These sources appear in two main classes: stocks and bonds. The two have distinct costs to the firm, and WACC is a subjective average of the entire price of getting funds via debit and equity.

Recent research shows a considerable decrease in cumulative percentage of Aveo group Weighted Average Cost of Capital. According to 2016 statistics the group WACC was recorded to have declined to a percentage of 3.4.The decline brought about several suggestions to the financial analysts. Briefly, the suggestions attempt to explain the reasons which might have led to this considerable decline (Pricing & Tribunal, 2013).

Price of equity basically is used by financial analysts to refer to the stockholders required return rate on the company equity investment. It similarly depicts the return rate that would have been realized by investing the cash in a different venture with an equivalent risk level.

Price of equity is a crucial factor of stock analysis. An investor will always expect an equity share to propagate by at least the price of equity; price of equity is commonly used as concession rate to compute an equity venture’s fair price. Considering the Aveo group scenario, lowering the terms of issuing equity will attract investors and this might have been the reason behind the decline in the average WACC (Arditti & Levy, 2014).

Price of debt basically denotes the rate at which a company recompenses its current debt. In most cases, it is used to refer to the after-tax price of debt; it can also denote to a firm’s price of debt before putting taxes into consideration. This measure is essential for giving a notch on the overall rate in the process of payment by a company using debt financing. The measure gives investors an insight on the company risk in comparison to the others; riskier companies usually have a greater cost of debt. Lowering the price of debt by the Aveo group might have attracted potential investors and hence reducing the WACC (Arditti, 2015) .

The WACC is settled through intricate calculations and conventions about the different types of capital (debt and equity) used by Aveo group to fund its operations. Costs are restrained against approximate risk elements. Greater subsidy costs and greater risks create a greater WACC. A lesser WACC increases incomes because the company can borrow cheaply (Brusov, et al., 2011).

Components of WACC

Calculating the WACC

Company’s possessions are funded by both debts and equity. For that reason, in calculating the company’s WACC the burden of equity and the burden of debt must be considered first. The equity market value of Aveo group also known as the Market Cap has been recorded as $M 1,388.The value of debt in the market typically being hard to compute, this paper uses the book figures of debt to carry out the calculations. According to the book value $0 (Bourdex & Long, 2013).

a)Weight of equity = E / (E + D) = 1,388 / (1,388 + 0) = 1
b) weight of debit = D / (E + D) = 0 / (1,388} + 0) = 0

This paper makes use of CAPM (Capital Asset Pricing Model) model to compute the required return rate. The formula used is: price of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market – Risk-Free Rate of Return) (Linke & Kim, 2013)
a) The paper evaluates a 10-Year Reserves Perpetual Maturity Rate as the risk-free rate. The current risk-free rate of Aveo group is 2.41000000%

1. b) Beta refers to the volatility of the anticipated surplus asset paybacks to the anticipated surplus market paybacks. Aveo group beta is 3.15
   c). This paper considers the market premium of Aveo group to be 20%.
   Price of Equity = 41000000%+ 3.15 * 20% = 63.241%

 The Price of Debt:
            The research uses last fiscal year end expenses on interest and divide them by the two year average debt to attain a simplified cost of debt; Cost of Debt = 0 / 0 = %.

 Multiply by one minus Average Tax Rate:
            The paper makes use of the current 2-year tax rate for computation.
The current 2-year Average Rate of Tax is 0%

The Aveo group WACC can hence be computed as:

Considering all the different components forming the weighted average cost of capital is the initial step to making efforts to lower it. With consideration to debt, firms can lower their cost of giving bonds by reducing the rates of interest they offer to the investors. They become more creditworthy as a result: Firms with bad credit ratings are forced to offer greater rates on bonds. The firm can also move to a location with a greater tax rate, but this is perhaps counterproductive (Ross, et al., 2013).

In regards to equity, a firm that offers stocks with small beta is a reduced amount of risky to the investors and consequently can offer small of a risk premium. The other components, the threat-free premium and the overall market risk, are outside of the firm’s control (Reilly & Wecker, 2014).

Factors Affecting WACC

The capital structure refers to how a company funds its general activities and development making use of different sources of reserves. Debt emerges in bond form issued or extended-term cash payable, whereas equity is classified as common/ preferred stock or reserved earnings (Nantell & Carlson, 2015).

Aveo group capital structure as per the recent research has indicated an ill proportion of equity to asset proportion. This simply shows that the company relies largely on debt capital as compared to its equity. Since a healthy proportion of equity capital indicates that a company is financially fit, this trend of Aveo group to rely mainly on debt is a clear indication that the company is financially unfit (Titman & Wessels, 2013).

The word capital structure is used to exemplify the proportionate connection between the numerous long-term categories of capital schedules the equity, debentures, inclination shares, long- term liability, capital excess, and reserved earnings. For a capital structure to be termed as appropriate, it must meet some important features (Brusov, et al., 2011),

The impression of adaptability gives the back administrator the ability to adjust the company’s capital structure with a base cost and deferral, if justified by the changed condition. It ought to likewise be workable for the organization to give reserves at whatever point expected to back its productive exercises (Bourdex & Long, 2013).

A sound capital structure should allow the greatest utilization of use at least cost in order to give better productivity and consequently expanding profit per share (Nantell & Carlson, 2015).

Broad obligation debilitates the dissolvability and FICO score of the organization. The obligation financing ought to be just to the degree that it can be overhauled completely and furthermore be paid back (if required) (Brusov, et al., 2011).

No organization ought to surpass its obligation limit. As of now clarified that the intrigue is to be paid on obligation and the foremost aggregate is likewise to be paid. These installments rely upon future money streams. In the event that future money streams are not adequate then the money indebtedness can prompt lawful bankruptcy (Evans & Kelvin, 2014).

The capital arrangement ought not to prompt loss of regulation in an organization.

An optimum capital arrangement is the best debt-to-equity ratio for Aveo Group in order to maximize its value. The optimum capital arrangement adoption by the Aveo group will offer a balance between the company’s ideal debts to equity level and minimize its price of capital. Theoretically, debt funding offers the lowest price of capital because of the tax deductibility (Brusov, et al., 2011).  

Capital Structure and WACC

In monetary terms, debt is a moral instance of the reputed 2-edged sword. Intelligent utilization of debt upsurges the aggregate of monetary assets available to a firm for its advance and enlargement. The postulation is that management can get additional on loan reserves than it recompenses in interest expenditures and charges on these reserves. Though, as effective as this formula may appear, it requires a firm to uphold a solid record of conforming to its numerous borrowing obligations (Bourdex & Long, 2013).

A company reflected to have high debts may find its liberty of actions limited by its creditors and its productivity offended as a consequence of repaying high interest costs. Of course, the situation is considered to be worst-case if the company faces distress meeting functioning and debt obligations in times of hostile economic circumstances. Lastly, Aveo group being a highly competitive firm, shuffled by huge debt, will find its opponents taking advantage of its hitches to seize large market shares (Harris & Raviv, 2015). 

Because dividends signify a form of revenue for investors, a company’s dividend policy is an essential contemplation for some investors. Intrinsically, it is crucial consideration for company management, particularly because firm leaders are often the prime shareholders and have the most to advance from a substantial dividend policy. Most firms consider a dividend policy as a fundamental part of the company strategy. Board must resolve on the dividend extent, timing and some other factors that impact dividend overheads over time. There are three categories of dividend policies: stable, constant and residual dividend policy (Titman & Wessels, 2013). 

The current analysis based on the Aveo group Analysis of Aveo group has shown an ill trend based on the dividend practices, this is depicted by its percentage stand of 3.91%. this is a low stand basically (Brusov, et al., 2011). 

This is the easiest and most frequently used policy by many organizations. The policy goal is to achieve steady and foreseeable dividend disbursements every year, which is what many investors really like (Teshtesh & Titus, 2013). When remunerations are up, shareholders get a dividend. Still when remunerations are down, investors as well receive a dividend. The goal is to support the dividend policy with the long-term advance of the firm rather than with periodical earnings instability. This approach permits the investor to have more confidence around the amount and scheduling of the dividend.

Aveo Group’s share price according to recent research shows it’s below the impending cash flow worth, and at a substantial discount of below 20 percent. Dividends per stake has gone down over the previous 10 years (Evans & Kelvin, 2014).

Dividend Policy and WACC

There have been falls in the general share prices in the Aveo group. The stock market is pretty impulsive, upsurge and decline in the share prices won’t shake its general business directly. Conversely, if there is a constant decline in share prices (Brusov, et al., 2011), it may discourage the firm from supplying more shares to increase revenue. For example, in the climate of stock market instability, firms wouldn’t have much assurance in supplying more shares as they would get a low profit. A large decline in share prices may cause broader economic hitches.

A firm may see a sharp fall in share value with respect to different firms (rest of money markets). This will happen if speculators are not hopeful about prospect of firm to make benefit and pay great profit. e.g. in the event that firm makes an extensive misfortune it won’t have the capacity to pay a profit to investors and this makes the offer less appealing (Bourdex & Long, 2013).

This decline in the offer cost could make the company powerless beside an assume control. This would apt an alteration in proprietorship. The new management may decide to adjust the approach for dealing with the organization. They could sale unfruitful parts of the corporate and significantly change things (Arditti, 2015).

Arditti, 2015. The weighted average cost of capital:some questions and its definition, interpretation and    use. journal of finance, Volume 654, pp. 34-45.

Arditti & Levy, 2014. The weighted average cost of capital as a cutoff rate, a critical analysis of weighted average. journal of financial management, Volume 567, pp. 234-254.

Bourdex & Long, 2013. weighted average cost of capital as a cutoff rate; a further analysis. s.l.:s.n.

Brusov, Filatova, Orehova & Brusova, 2011. weighted average cost of capital in the theory of modigliani-miller, modified for finite lifetime company. journal of applied economics, Volume 234, p. 56.

Evans & Kelvin, 2014. corporate perfomance analysis. journal of recent finance states, Volume 8765, p. 564.

Harris & Raviv, 2015. The theory of capital structure. journal of finance, Volume 254, p. 34.

Linke & Kim, 2013. More on weighted average cost of capital: a comment and analysis. journal of  financial and quantitative analysis, Volume 987, p. 345.

miles & Ezzell, 2012. the weighted average cost of capital, perfect capital markets and project life.   journal of financial and quantitative analysis, Volume 2345, pp. 123-145.

Nantell & Carlson, 2015. The cost of capital as weighted average. journal of finance, Volume 567, p. 76.

Pricing & Tribunal, 2013. Weighted average cost of capital. journal of economics, Volume 765, pp. 123-   345.

Reilly & Wecker, 2014. On the weighted average cost of capital. journal of financial and quantitative      analysis, Volume 876, p. 234.

Ross, Westerfield & Jaffe, 2013. Corporate finance. s.l.:s.n.

Teshtesh & Titus, 2013. the basics of dividend policy. journal of corporate finance, Volume 453, p. 34.

Titman & Wessels, 2013. choices of capital structure in the economy analysis. journal of finance, Volume  453, p. 45.

Titman & Wessels, 2013. determinants of capital structure choice. journal of finance, Volume 1097, p.    543.

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