BLOG3 Weighted average cost of capital and optimal capital structure

The definition of weighted average cost of capital (WACC) is a weighted average method of calculating a company's cost of the capital that according to the weight of all the capital in the total source of capital. Sources of capital include common stock, preferred stock, bonds and all long-term debt. Each source of capital has the different capital cost and proportion. The formula of WACC is to evaluate the overall cost level of capital of a company.

For example, When you want to run a business and put in £10,000 in the capital. The bank will lend 60% and the shareholders will contribute 40%. In addition, the corporate income tax is 19%, and the bank loan interest rate is 6%. First of all, the interest rate of the bank is the pre-tax cost of the cost of the debt, we have to figure out the after-tax cost of the bank. (K= 6% x (1-19%) = 4.86%) Then, we figure out that WACC is equal to 6.516% (40% x 9% + 60% x 4.86% = 6.516%) which calculated in this way can reflect the actual situation of a company and expected capital structure. The lower WACC ratio, the lower the cost for a company to raise capital, which increases returns on capital and creates more profit for shareholders.

The WACC is one of the most important indicators reflecting the optimal capital structure of a company. If we want to reduce WACC further, we can substantially increase the proportion of debt capital (bank loan) in the capital structure. But this can increase a company's debt risk. The more debt a company borrows, the more interest it pays that would increase the ability to pay off debts and increase the risk of financial crisis. Although the WACC is one of the main parameters to determine the optimal capital structure, the lowest capital structure in the WACC is not necessarily the healthiest.

In brief, Berglof & Thadden (1994) believes that the capital structure with multiple investors having both short-term and long-term interests is better than the capital structure with only one class of interests, and the optimal capital structure should be the combination of equity and creditor's rights and short-term and long-term creditor's rights

References:

Berglöf, E., & Von Thadden, E. L. (1994). Short-term versus long-term interests: Capital structure with multiple investors. The quarterly journal of economics, 109 (4), 1055-1084.

'What is WACC, it is formula, and why it's used in corporate finance', Corporate Finance Institute.https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-wacc-formula/.(Accessed 08 Nov 2019)