Changes in Bond and Stock Prices

Changes in Bond and Stock Prices

The Weighted average cost of capital (WACC) of a business refers to how much it costs an entity to source the capital it requires to operate. As a business needs a lot of capital for normal operations, it may get finances from the shareholders or borrow loans from banks and other financial institutions. Hire our assignment writing services in case your assignment is devastating you.

The business pays a cost for this large sum of money. The cost payable is referred to as the cost of capital. Most firms have more than one source of operational funds. In such a case, we need to calculate a weighted average cost of capital. This paper focuses on discussing the importance and process of calculating WACC. (Velez-Pareja, 2009)

Importance of WACC

WACC is very important in the day-to-day decisions of a business. It brings out clarity on the implications of financial decisions in an entity. WACC will enable decision-makers to understand the following financial aspects before they venture into a business activity:

• The amount of interest the company has to pay for every dollar it finances. This enables a company to decide on whether to go for the financing or not. It can also help in deciding between two financial options available. The option made here will help maximize profits made by the firm per every dollar invested.
• Also calculated WACC will reflect what a firm needs to earn on every dollar channeled in a new investment. This consideration is crucial in determining which business activities an entity want to pursue. The decision makers will use this information to determine whether the business is worth venturing into.
• WACC shows the value (earning potential) of a business. The higher the WACC the lower the earning potential, the lower the WAAC the higher the earning potential. Potential investors may use this information in deciding whether to engage with the company or not. Most investors would like to be assured of high returns on their investments.
• Knowing a firm’s WACC will enable them make an effective decision on how to obtain funds. For a company looking to lower its WACC, it may consider going for alternative sources of finance that are cheaper. This may involve issuing more bonds as opposed to stock. This will lead to a decrease in the company’s weighted average cost of capital. (Pricing & Tribunal, 2012))

 Use of WAAC in decision-making

Financial decisions in a business are aimed at maximizing the profits. This will depend not only on investment decision but also on the financing decisions made and the interactions between the financing decisions and investment decisions. It therefore comes out clearly that WACC is an important tool in coming up with these decisions.

For instance, a company with a higher WACC may aim to lower the WACC so as to increase its value. This will involve the two aspects mentioned above as discussed below:

• Financing decisions have an influence in the WACC of any given firm, such a company may have to reconsider their financing choices. All it has to do is to go for cheaper sources of capital. For instance, it may involve dropping a lending institution with higher interest rates and consider cheap ones.
• The company may as well reconsider the choice of investment activities they engage in. How much they earn per dollar, they put in operation. Is the investment giving back the value of their money? If not, they may have to switch to a more profitable investment. (Modelling, 2018)

Components of WACC

A company gets its funds from debts (bonds) and equity (stock). In calculating WACC, the main consideration is placed on how much the company has in terms of stock and the value of its debt. This will give us the value of the company (equity + debt). (Pricing & Tribunal, 2012)

How do we estimate the Cost of Debt?

The debt of a company can be estimated using two approaches. In the first approach, we look at costs payable on debt in terms of interest and then later the principal debt in time. This approach is referred to as the YTM (yield to maturity) of a firm’s debt. For example, a straight bond involving regular interest payments and then paying back the principal when it matures. This method is normally used in firms with simple capital structures, i.e., those that don’t have several debts, including ones accruing different rates of interest.

The other approach is to use reports from firms specializing in credit rating, like Fitch, Moody’s, and S&P. In this approach, a company will evaluate the report based on its current credit rating in comparison to its debts to estimate the cost of its debt. This approach is very common in firms that do not have an open cost of debt out in the market. For instance, private companies.

How to estimate the cost of equity

The cost of equity is not as straightforward to calculate because share capital carries no “explicit” cost, unlike debt. Common shareholders expect a certain return on the stock they invest in a company. If the company fails to meet this expectation, the shareholders will not be satisfied. They may end up selling their shares, causing the company to drop in value. Therefore, the cost of equity simply refers to how much the company will have to pay to satisfy the investors, therefore maintaining their share.

Limitations of WAAC

WACC differ from one calculation to another. This results from inconsistent values of various elements such as cost of equity. Different parties report different values for similar elements for various reasons. It is therefore highly recommended to use WACC along with other metrics when determining whether to invest in a company or not.

References

Modelling, C. (2018). Learn Financial Modelling | Become a Financial Modelling Analyst |         DeZyre Online Course. [online] Dezyre.com. Available at:   https://www.dezyre.com/Financial-Modelling/1 [Accessed 22   May 2018].

Pricing, I., & Tribunal, R. (2012). Weighted average cost of capital.

Velez-Pareja, I. (2009). The Weighted Average Cost of Capital (WACC) for Firm Valuation Calculations: A Reply. SSRN Electronic Journal.

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Changes in Bond and Stock Prices

Week 6 – Assignment: Estimate and Forecast Changes in Bond and Stock Prices

Instructions

Use the That’s WACC. The Best WACC Calculator to generate estimates of the weighted average cost of capital (WACC) for five different companies (pick companies from different industries such that you find a relatively wide range of WACC estimates):

Build a three-column table displaying the full company name and its stock symbol in the first column, a brief description of the company and its main line(s) of business in the second column, and the company’s WACC estimate (the value given in the From Financial Statements column) in the third column.

Below your table, write an essay discussing the importance and process of calculating the weighted average cost of capital. The list below suggests some (though not all) of the topics that you should address in your paper:

• Why do firms need to know this value?
• How is the weighted average cost of capital used to make decisions?
• What are each of the components of the weighted average cost of capital, and how are each of these components estimated?
• What are some possible reasons why the WACC’s in your table differ from one another? Be sure to discuss the relationship between risk and expected return as reflected in bond and stock yields.

You must use a minimum of three (3) scholarly sources for your paper.

Length: 3-4 pages, not including title page and references