Capital structure
Capital structure is the mix of long term borrowing, short term borrowing, common equity and preferred equity that a company uses to finance its operations and its growth. This means that a company’s capitals structure is the combination of common equity, preferred equity and borrowing that has been employed to finance the assets, growth and operations of the company.
The weighted average cost of capital is calculated using the following formulae
WACC = E/V*Re + D/V*Rd*(1-Tc)
Where: Re is the cost of equity, Rd is the cost of debt, E = market value of the firm's equity, D = market value of the firm's debt, V = E + D, E/V = percentage of financing that is equity, D/V = percentage of financing that is debt and Tc = corporate tax rate.
In the case of Apex ltd, the corporate tax rate is 35%, the cost of debt is 8%, the beta of the company is 1.5, the risk free rate is 2% and the market rate of return is 11%. The capital structure of the company is made up of 60% equity and 40% debt.
Since the cost of equity is not provided, it will be calculated as follows:
Re = Rf + β * (Rm – Rf)
Where Re is the return on equity, β is the company’s beta; Rm is the market return while Rf is the risk free rate. Therefore, the return on equity will be calculated as follows;
Re = 0.02 + 1.5(0.11-0.02)
Re = 0.155 =15.5%
With the return on equity, it is now possible to calculate the weighted average cost f capital using the formula;
WACC = E/V*Re + D/V*Rd*(1-Tc)
WACC = (0.60*0.155) + (0.40*0.08*0.65)
WACC = 0.093 + 0.0208
WACC = 0.1138
WACC =11.38%
Importance of WACC in capital Budgeting
The weighted average cost of capital is important in determining the feasibility of a capital project because it gives the minimum rate at which the project should yield return so as to recover the funds invested. It also shows the minimum return that the project must yield so that the company can fully meet the interest payments to all those parties which have provided debt funding to the company, its creditors and owners.
Recommended project evaluation
I would recommend that Apex limited make use net present value method in evaluating its capital projects. This is because unlike the weighted average cost of capital, the net present value method takes into account the present values of future cash flows. This enables a realistic view on the returns of the project since changes which may result in the erosion of the values of the returns of the project are taken into account.
In using the NPV, it is also possible to use different rates of returns for different periods. This is not possible when using other methods of capital budgeting.
Marginal cost of capital
Marginal cost of capital is the cost associated with the raising of one more unit of capital. It differs from one type of capital to the other. For example, raising capital through unsecured debt will be higher than raising capital through secured debt due to the high interest rates which will be demanded to cover the higher risk of unsecured debt. Therefore, the cost of raising one more unit of unsecured debt will be higher.
References
Brigham, E. & Ramon, J. (1980). Issues in Managerial Finance, Holt Rinehart and Winston Publishers, Hindale Illinois.
Gitman, Lawrence (2003). Principles of Managerial Finance, 10th edition, Addison-Wesley Publishing.
Weston, F. & Brigham, E. (1972). Managerial Finance, Dryden Press, Hinsdale Illinois.
