Evaluation of The Significance of The Weighted Average Cost of Capital (wacc) and Its Functionality in Growing a Local Venture

The simulation that will be discussed in this paper concerns the decisions that a coffee shop's owner needs to make in order to expand their business. The name of the shop is El Café and in located in Minnesota. The owner has decided to expand the business because it is becoming profitable and expanding the business is the next logical step. There is a rich uncle that is willing to help the owner by allowing him to utilize his cash assets. Following will be a short discussion on the importance of weighted average cost of capital (WACC) and what impact WACC has on capital budgeting and structure.

For the first scenario the owner needs to raise $400,000 in adequate financing in order to expand operations by two shops. The scenario calls for a determination on whether to get a debt zero tax and low interest loan or to use the equity that Uncle Jorge has in the company. The decision was made on the debt-equity mix to do 70% debt and 30% equity. With this decision we have achieved the lowest WACC of 8.65%. By doing so, it also allowed the company to not put too much leverage on the company with too much debt. Otherwise, the company would have a substantial part of earning by meeting the high debt obligations.

For the second scenario, four years have passed and the company is looking at expanding into other cities. Doing so would accelerate growth and create a market for the company. The decision that needs to be made is how many cities to expand into and which source of funding to use. The decision was made to expand to 7 cities with debt to ensure that the projected rate of return was higher than the WACC. Choosing all debt-financing lowered the WACC but it was still a better decision to go with debt. The reason was to decrease taxable income because of the increase of debt. Utilizing the tax-shield was the best option to take because the company was doing well financially.

For the final scenario, there is a large amount of debt that was accumulated in scenario 2 and the company is having financial issues. If there is not a decrease in debt, the company will need to claim bankruptcy and will be up for sale. The decision that will need to be made is to determine if there should be a debt equity swap, if there should be a selling of assets, or possibly a loan-renegotiation. The decision was made to convert 25% debt into equity which allowed the company to lower the debt amount of the capital structure by one third of the original debt amount. There was also a decision to sell real estate assets because the company can lease back the land in the future. As for renegotiations, it would be very difficult to negotiatione more than 25% of the loan because it would have put a higher burden on the company due to lenders charging higher rates in the future.

When looking at the WACC, it is important to understand what it is about. It is recognized as one of the most critical parameters in strategic decision-making. It is relevant for business evaluation, capital budgeting, feasibility studies and corporate finance decisions. When estimating the WACC for a company, there is a clear trade-off between guesstimates and actual circumstances faced by a company. The decision should reflect the actual environment in which a company operates. (McLure, 2003)

To understand the Weighted Average Cost of capital, you must understand what story it tells. The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so WACC tells the company owner what return that both stakeholders - equity owners and lenders - can expect. WACC, in other words, represents the investors' opportunity cost of taking on the risk of putting money into a company. (McLure, 2003)

Investors use WACC as a tool to decide whether or not to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. WACC also serves as a useful reality check for investors. Furthermore, the average investor probably would not go to the trouble of calculating WACC because it is a complicated measure that requires a lot of detailed company information. Nonetheless, it helps investors know the meaning of WACC when they see it in brokerage analysts' reports. (McLure, 2003)

As for the capital structure of a firm, it is comprised of three main components: preferred equity, common equity and debt. The WACC takes into account the relative weights of each component of the capital structure and presents the expected cost of new capital for a firm.

WACC is a strong tool that is used by most all investors. It was important to look at in the scenerios as it helped determine what direction to move toward. It was also very helpful to the owner to understand the outcome of the decision and what investments to take.