ACC501 GDB no 2 full solution fall January 2011-2012

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Discussion Question:

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Suppose you were hired as an Assistant Finance Manager in a leather manufacturing concern last month. The first task assigned to you was to calculate company’s weighted average cost of capital (WACC) and provide a detailed report about it to the CEO of the company. Although you have calculated the WACC after incorporating the required data but the problem is there in reporting it to the CEO because he doesn’t have enough financial knowledge. For him, the WACC is just a rate that is used in different financial affairs of the company whereas you have to make him understand the financial usages of WACC. You are, therefore, required to identify the different financial usages for which this particular rate can be used by the company.

NOTE: You are required to provide at least four different financial usages in bulleted form only. Avoid unnecessary details.

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Acc501 Current Gdb Idea Solution 2012

Idea solution:
By taking a weighted average, we can see how much interest the
company has to pay for every dollar it finances.
it is often used internally by company directors to determine the
economic feasibility of expansionary opportunities and mergers.
It is the appropriate discount rate to use for cash flows with risk that
is similar to that of the overall firm.
It gives companies an insight into the cost of their financing, can be
used as a hurdle rate for investment decisions, and acts as a measure
to be minimized to find the best possible capital structure for the
company
Investors use WACC to help decide whether a company represents a
good investment opportunity. To some extent, WACC represents the
rate at which a company produces value for investors—if a company
produces a return of 20% and has a WACC of 11%, then the company
creates 9% additional value for investors. If the return is lower than
the WACC, the business is unlikely to secure investment.
If the management does not have a good understanding of the
WACC Weighted Average Cost of Capital of their firm, then they will
not be able to make good investment decisions that will benefit the
shareholder.
By understanding how the WACC Weighted Average Cost of Capital
is calculated, a firms management can choose a capital structure that
will provide the highest possible return for their shareholders relative
to the perceived risk of the company. It is important to understand
that increasing the amount of debt in a company will reduce the
WACC Weighted Average Cost of Capital. When this happens, the
hurdle rate for capital projects is lowered and projects that were
previously rejected may now be approved. But this does not
necessarily mean that shareholders will benefit. By increasing
leverage, the company has increased the risk to shareholders that
returns could be reduced due to the higher amount of interest that
need to be paid. It is important to understand the risk expectations of
shareholders when making changes to the capital structure.