Smith Co.: Weighted Average Cost Of Capital

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Definition
Capital structure refers to the configuration of capital sources a company uses to finance its day-to-day activities. As capital is typically raised through some blend of equity and debt, capital structure refers to the mix of debt (long-term bonds and loans) and equity (preferred and common shares) used by a company. Currently, Smith Co. has a capital structure of 23% debt and 77% equity.
Optimization
To determine what capital structure to use for Smith Co, it is important to first understand what defines an optimal capital structure. Capital optimization is a mix of debt and equity that will minimize Smith Co.’s cost of financing, which will in turn minimize the cost of capital and maximize value. There are a couple elements that …show more content…
projects that in years to come that the company will not be profitable, equity financing may be preferred.
Weighted Average Cost of Capital
Definition
The weighted average cost of capital (WACC), is an entity’s overall cost of capital – that is, the return that providers of the capital to an entity require on their invested funds. As mentioned, the optimal capital structure is the specific proportionate weight of debt and equity that will make Smith Co.’s WACC the lowest percentage possible.
Effect on WACC when Adding Debt or Equity
The cost of equity is typically greater than the cost of debt due to the increase in tax savings; therefore, when you add debt the WACC tends to decrease. However, a company’s risk tends to increase with added debt. If interest rates rise the cost of debt and overall cost of capital will increase. The more debt added, the more difficult it becomes to meet debt obligation which could lead to bankruptcy.
As mentioned, Smith Co.’s current capital structure is 23% debt and 77% equity. If the company decides to proceed with the $2M financing, the structure will change to 33% debt and 67% equity, which is much closer to the industry average of 35% debt and 65% equity. I have determined the effect of this potential capital structure change and how it effects WACC …show more content…
The scenarios and their results are as follows:
• Using Smith Co.’s current weights of debt and equity o WACC – 21.29%

• Assuming Smith Co. proceeds with the new $2M financing o WACC – 19.67%
It is important to note when debt is added, generally cost of equity rises. For simplicity, I have made the assumption that cost of equity will not change in this calculation.
Recommendation
Based on my quantitative analysis of Smith Co.’s WACC, I recommend that the company proceed with the new financing, as the overall cost of capital is lower.
Purchasing New Equipment Decision
Issue
The issue is whether Smith Co. should purchase the new equipment based on the quantitative factors.
Analysis
I have quantitatively analyzed the decision to purchase new equipment in tab 3 of the attached excel workbook. Using the new WACC of 19.67%, the net present value (NPV), in relation to purchasing the new equipment, is $87,849. NPV is used in capital budgeting to analyze the profitability of a projected investment of project, as it is the calculation of the present value of future cash receipts from the investment. Therefore, a positive NPV indicates a profitable
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