BAB 5 CAPITAL STUCTURE AND COST OF CAPITAL

Summary

The video provides a comprehensive overview of the Weighted Average Cost of Capital (WACC), its significance in company valuation, and its application in making financial decisions. It explains how WACC serves as a discount rate for valuation, evaluates investment feasibility, measures overall capital costs, assists in financing decisions, and helps assess profitability through comparisons with ROIC. The lecturer emphasizes the importance of efficient capital structure and encourages students to take notes for better understanding. Overall, the video aims to deepen viewers' understanding of WACC’s role in corporate finance.

Takeaways

• 😀 WACC (Weighted Average Cost of Capital) is a key concept in company valuation, acting as a discount rate for project assessments.
• 😀 WACC is used to evaluate whether an investment project is financially viable. If the project's return is higher than the WACC, it adds value.
• 😀 A project's feasibility can be assessed by comparing its return with the WACC; if the return exceeds WACC, the project is considered financially sound.
• 😀 WACC combines the cost of equity and the cost of debt to provide a more complete picture of a company's capital costs than using either cost individually.
• 😀 Evaluating WACC also helps companies assess if their capital structure is efficient or if it needs to be revised.
• 😀 WACC plays a significant role in funding decisions, especially when deciding between taking on more debt or issuing more equity.
• 😀 When increasing debt lowers WACC within acceptable risk levels, debt financing can be a cost-effective strategy for the company.
• 😀 On the flip side, if increasing debt raises WACC beyond a tolerable risk, the company should avoid excessive borrowing.
• 😀 WACC can be compared with ROIC (Return on Invested Capital) to assess profitability. If ROIC exceeds WACC, the company is generating value.
• 😀 If ROIC is lower than WACC, the company is not creating sufficient value, and this could result in a decrease in company value.
• 😀 WACC is a fundamental tool for both financial analysis and strategic decision-making, helping guide investment choices and capital structure decisions.

Q & A

What is the role of WACC in company valuation?

WACC is used as the discount rate in company valuation. It helps determine the present value of a company's future cash flows by accounting for the cost of both equity and debt.

How does WACC help evaluate the feasibility of an investment project?

WACC is used to assess whether an investment project is financially viable. If the return on the project exceeds the WACC, it adds value to the company. If the return is less than WACC, the project may not cover its costs.

What does WACC tell us about a company's cost of capital?

WACC combines the cost of equity and the cost of debt to provide a complete view of a company's overall capital costs. This helps evaluate whether the company’s capital structure is efficient or requires adjustment.

How can WACC assist in making financing decisions?

WACC can guide financing decisions, such as choosing between debt or equity. If increasing debt lowers WACC while keeping risk at an acceptable level, it may be a cost-effective strategy. However, excessive debt could increase the risk beyond tolerable limits.

How does WACC relate to profitability measurement?

WACC can be compared to Return on Invested Capital (ROIC). If ROIC exceeds WACC, the company is generating value. Conversely, if ROIC is lower than WACC, the company's value may decrease.

What is the significance of the cost of equity and cost of debt in calculating WACC?

The cost of equity and cost of debt are both essential components in calculating WACC. The cost of equity represents the return required by equity investors, while the cost of debt represents the interest the company pays on its borrowed funds.

Why is WACC an important metric for companies to track?

WACC is important because it helps companies assess the efficiency of their capital structure, evaluate investment opportunities, and make informed decisions about financing and risk management.

What does it mean if a company’s ROIC is lower than its WACC?

If a company’s ROIC is lower than its WACC, it indicates that the company is not generating enough return to cover its cost of capital, which could result in a decrease in the company’s overall value.

How does WACC affect a company’s risk tolerance?

WACC affects a company’s risk tolerance by determining the level of return required to satisfy both equity and debt holders. If a company takes on too much debt, it can lower WACC but may increase the overall financial risk, which could exceed the company’s risk tolerance.

What factors should a company consider when adjusting its capital structure based on WACC?

A company should consider the cost of equity, cost of debt, the risk profile of the company, and its ability to handle debt when adjusting its capital structure based on WACC. The goal is to optimize the capital structure to minimize costs and manage risk effectively.