WACC- How to Calculate?by Craig Stewart Chief of Marketing & Sales
WACC is a weighted standard cost of debt, equity and shares of preference. Weights are the capital percentage sourced from every element correspondingly in value terms of the market. It is mostly called the overall capital cost for the firm as a whole. The WACC can also operate as a hurdle rate in calculating the new projects given the assumptions for those projects are correct as per our financial accounting homework help experts. The structure or capital mix of the new scheme investment should be similar as the structure of the existing firm (David). When the firm has a ratio of 70:30 of debt to balance in their latest balance sheet, involvement of the new scheme will retain the same. In addition the risk accompanied with the new scheme will be similar to the existing schemes. Example a textile production increases and expands the supply of looms from 60 looms to 100. Due to similar business and industry, there will be no difference in the profile risk of current production and the new development.
The major advantage of WACC is its simplicity. When calculating, it does not require complications. The manager will just apply weights of every finance source with its cost and total the result. Also, a single rate of hurdle for schemes saves managers’ time in calculating the new projects (David). If the schemes are of similar profile risk and there is no difference in the structure of proposed capital, the latest WACC can be instituted and effectively applied. Another advantage is that accurate decisions have to be applied at the accurate time (Gleißner and Femerling p8). Since all new schemes use single rate, the decisions can be reached quickly and new opportunity grabbed and benefits taken.
The disadvantages can be traced from the applicability assumptions of WACC. The limitations and practicability of the assumptions are difficulty in the capital structure maintenance. The unreasonable assumptions of no difference in capital organization has exceptional possibilities of persisting all the time (Gleißner and Femerling p19). It shows similar capital organization for new schemes as per the analysis done by our taxation homework help analysts. This process has two possibilities for its funding. First, one requires funding using the retained earnings (Paul). In the case assumption, the new scheme is funded using similar capital organization. There is lack of free cash with the firm. Even if free cash is present, it will create a cap on the investment size (Paul). Example if the new scheme needs US D.100 million the firm can only raise USD. 70 Million. What about the USD. 30 Million? Secondly increasing fund in similar capital mix. The main concern of company management is to reduce the capital cost as low as needed to enable them achieve the profits of shareholders and maximization of wealth. Another disadvantage is taking poor projects and rejecting the quality ones. The assumption can be considered right if the firm is growing its own company and similar business. Example the textile company, it can be false due to the risk accompanied with putting looms being different since the past. The technology may be complicated and different. The cost and quality methods may differ. In the concept of firm growing in different industry, the case might prove malicious due the heavy machineries and FMCG lacking similar risk profile as per our finance assignment help experts. In this case, the WACC should be corrected to take the difference in risk effectively.
The WACC disadvantage in the case of difficulty in obtaining latest market capital cost is used for calculation of new schemes. Knowing such sums and the latest day of capital cost is hard. The WACC focuses mainly on preferred, debt and equity. The interest debt cost changes in the market due to economic differences. Also another disadvantage is that the significant capital sources are avoided. When carrying out WACC evaluations, only preference, debt and equity shares are preferred in place of simplicity in assumption that they take major part of the capital. The reason for errors is complexity. The short run borrowings and the credit trade cost is also not considered. If such factors are instituted, WACC will definitely be transformed.
Created on Oct 25th 2017 09:00. Viewed 262 times.