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

Financial Management
1

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%
2