Balancing Debt & Equity

October 9, 2020

Weighted Average Cost of Capital (WACC) Practice Questions & Solutions

Generally, companies finance operations, expansions, etc. with either debt (such as bank loans and bonds) or equity (such as common and preferred stock). Debt is often preferred, because it is less risky than is issuing stock.

However, as a company acquires larger amounts of debt, lending institutions consider the company to have a larger likelihood of defaulting on the loan and, therefore, charge a higher interest rate. Thus, businesses aim to strike the optimal balance between debt and equity, which is referred to as its Weighted Average Cost of Capital (WACC). 

An underlying concept for WACC calculations is understanding why profitable businesses borrow money.

WACC calculation

When a Company Has a Profit, It Can Use It to Do One or More of the Following:

  1. Accrue minimal interest in a bank account, 
  2. Pay out dividends to its stockholders,
  3. Invest in stocks, bonds, land, or other assets, and/or
  4. Invest in the company itself via research, expansion, updating equipment, etc.

The Why & How of Company Investments

Investment funds are limited to company earnings unless the company acquires funds through debt or equity methods. Companies invest in order to increase value for shareholders, but investment earnings must be weighed against the associated costs, including the financing rate needed to acquire capital.  

These Concepts Are Illustrated in the Sample Question Below:

JLW Corp.’s management has determined the following interest rates, related to issuing debt, and returns on revenue, related to issuing equity. These rates were based upon borrowing different, increasing amounts of debt. Which combination of debt and equity yields the optimal cost of capital for JLW Corp.? 

WACC Sample Question

Interest expense paid on debt can be subtracted from income, thus reducing company taxes, so debt calculations are reduced by their tax benefit when calculating WACC. The impact of the interest/revenue returns on total funding is weighted according to the related percentages of total funding.

To illustrate the weighted-average method, the calculations for the optimal capital structure (row 3 in the chart above) are detailed below.

  • Debt = .09 (interest rate) x (1 – .21) (tax benefit) x .5 (% of total funding) = .0356 (rounded rate)
  • Equity = .12 (return on revenue) x .5 (% of total funding) = .06

Total capital financing rate based on 50% debt and 50% equity = .0956.

A company’s capital structure is used as a means of evaluating investment opportunities, because any investment that yields a lower return than the company’s WACC is a losing investment. Stated differently, if the company’s cost to acquire funds is 9.56%, it should invest only when returns on investments of about 10% or greater are expected.  

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