Determining Capital Structure and Weighted Average Cost of Capital (WACC)

This report explains the importance of developing an adequate capital structure for realizing maximum returns from a project. It also calculates the WACC for Apex Printing project and recommends the use of WACC or NPV method for determining project feasibility. The report also discusses the concept of marginal cost of capital.

Financial Management
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Introduction
The present report is developed for providing an understanding of determining capital
structure and Weighted Average Cost of Capital (WACC) for assessing the feasibility of a
project. In this context, it has calculated the WACC for Apex Printing for assessing the required
return for the project planned to be undertaken. Apex Printing is determining to calculate the
return for the intended project for assessing its adequate capital structure. Lastly, it also provides
a recommendation that is appropriate to be applied for evaluation of the project feasibility.
1. Capital Structure Description
Capital structure is regarded as various types of sources of funds such as debt and equity
used by a company for create an optimum capital base to realize larger returns. The different
types of capital components that are used in a capital structure determine the financial risk and
returns. The larger proportion of debt in the capital structure increases the financial risk. This is
because the investors would interfere in the company decisions and also can increase the cost of
capital in the form of interest repaid for meeting the debt obligations. It can also result in
decreasing the profitability of a company as interest need to be repaid for meeting the cost of
debt (Armitage, 2005). This in turn also negatively impacts the company’s liquidity as large
amount of cash outflows occurs for paying the cost of debt. The increase in equity in the capital
structure also leads to a decline in the returns provided to the investors as large amount of
dividend need to be paid to the shareholders. Thus, it is essential for a company to develop an
adequate capital structure consisting of right proportion of debt and equity for realizing
maximum returns and reducing the cost of capital (Baker, 2011).
2. Calculation of Weighted Average cost of capital (WACC)
Formula to calculate the weighted average cost of capital: [(weight of equity) x (cost of equity)]
+ [(Cost of Debt) x (Weight of Debt) x (1-tax rate)]
Before tax cost of debt is 8% and tax rate is 35%, therefore, after tax cost of debt will be 8% (1-
0.35) = 5.2%
To calculate the cost of equity there is need use of capital asset pricing model (CAPM) that will
help to ascertain the cost of equity through formula: (Rf) + [B(Rm – Rf)] where Re = Cost of
equity, Rf = Risk free rate, B =Beta and Rm = Return on the Market.
Information provided to calculate the cost of equity:
Beta of Apix Printing B 1.5
Risk free rate Rf 2%
Return on the market Rm 11%
Expected return or cost of equity using
CAPM model
2% + 1.5(11%-2%) = 15.5%
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Application of WACC on Apix Printing
Weight of debt 40%
Weight of Equity 60%
Cost of debt (after tax) 5.2%
Cost of Equity 15.5%
WACC (0.60*15.5%) + (0.40 * 5.2%) = 11.38%
(Armitage, 2005)
3. Usefulness of WACC for determining the Project Feasibility
Weighted average cost of capital (WACC) method can prove to be very useful for
evaluation of the project feasibility. This is because it is highly useful for calculating the cost of
capital of by including all the capital sources such as stock, bonds and debt sources. WACC
determines the minimum rate of return at which a project is able to create value for its investors.
For example, if the return realized form a project is 20% and it has a WACC of 11% then it
depicts that for every dollar invested into the project it is able to create nine cents of value. On
the other hand, of the returns realized form a project is less than WACC then it depicts that the
project is not feasible (Pratt, 2010).
4. Recommendation of other method than WACC for project evaluation
Net present Value (NPV) is also regarded as an important method for determining the
potential value of a project. The method evaluates the worth of a project by assessing whether
the return realized from it outweighs the cost. It is regarded as the sum of the present values of
all the expected cash flows by assessing a discount rate that indicates the cost of capital of a firm.
The future returns to be realized from a project are discounted to the present for comparing it to
the present value for determining its feasibility. The positive NPV of a project indicates the
increase in the wealth of shareholders while a negative value indicates the decline in the value
created for shareholders. However, if the NPV of a project is calculated to be zero then it
indicates that there is no impact on the wealth of shareholders. Thus, it can be said that the
method of NPV is an important technique for analyzing the profitability of a project and can be
used as an alternative to the method of WACC (Damodaran, 2010).
5. Marginal Cost of Capital
Marginal cost represents the additional cost that has to be incurred during a project for
delivering enhanced output. It is calculated by assessing the overall change in the cost incurred in
production of goods and dividing it by the change in the quantity of goods produced (Brigham,
2012).
Conclusion
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It can be stated form the overall discussion of the report that developing an adequate
capital structure is very essential for realizing maximum returns from project, The sue of WACC
or NPV method can be used by the project manager for determining the potential value of a
project.
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References
Armitage, S. (2005). The Cost of Capital: Intermediate Theory. Cambridge University Press.
Baker, K. (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment
Projects. John Wiley & Sons.
Brigham, E. (2012). Fundamentals of Financial Management. Cengage Learning.
Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
Pratt, S. (2010). Cost of Capital: Applications and Examples. John Wiley & Sons.
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