A closer look at the calculations done on the weighted average cost of capital, there are various components that have been used in making sure that the we get the cost of capital that cuts across the three components that is; the cost of common equity, the cost of debt and the cost of preferred equity. In our case of McDonald’s Fast Food there were no preferred equity capital which made the company to have only two components which are the common equity capital and the debt capital (Pratt, & Grabowski, 2014). From the calculations of the weights of the component, the debt capital has a higher percentage which stands at around 81% than common equity which stands at around 19%. This means that the company is highly leveraged hence the interest expense on debt is clearly higher at this point (Pratt, 2012).
High gearing ratio makes a company be in terms of the stability of its net worth and hence the ability to borrow is expected to shrink. The best remedy for this notion is to sell more shares to the public so as to increase the share capital. The proceeds from the sale of share should be used in offsetting the outstanding debts in order to reduce the debt equity ratio for the company. On the calculations of the tax rate, the tax expense has been divided by the income before tax (Pratt, 2012). The main reason for the calculation of the tax rate is to use it in the calculation of the after tax cost of debt. The after tax cost of debt is arrived at by reducing the cost of debt by the tax rate (1-tax rate) hence the cost of debt of 1.61% is reduced to 1.11%. The main reason for this reduction is to relieve the cost of debt from any taxes that might be delusional in the finding of the real cost of debt (Patterson, 2015).
In order to get the real cost of common equity, the capital asset pricing model (CAPM) has been used. The components of the CAPM include the risk free rate, the company stock’s Beta and the market return. The risk free rate is found by getting the interest rate on the treasury bonds which are deemed to have no risks when being invested in since the government is believed not to default in payments of its bonds. The stock beta is the systematic risk factor that is used to incorporate the volatility risk that occurs to the company. The market return is the prevailing market return on the stocks making the top 500 stocks to be the benchmark for the same (Pratt, 2012). The results of the components show that cost of debt is higher than the cost of common equity. The main reason for this is the fact that the market return for the stock is negative and hence this reduces the cost of common equity since it is a component that has a directly proportional effect to the outcome of the required rate of return. Thus when it is used in the CAPM model it has the effect of reducing the cost of common equity.
A closer look at the derivation of the weighted average cost of capital, the two weights have been used in accordance with the proportion of debt and equity as quoted in the balance sheet. The WACC is therefore a combination of the two components of capital in the proportions of their weightings. The final result of the WACC stands at 0.958% which is below the industry average (Pratt, 2012).
In the event that we use the market value of the common equity rather than the book value, it is expected that the weighted average cost of capital to reduce. The main reason for this reduction is that the book value of the share is lower than the market value of the shares. This means that the total value of the shares will go up and so is the weights or the proportion of the common equity while the proportion for debt will reduce (Jorgenson, Yun, & Oxford University Press. 2011). From the calculations, the cost of capital for the common equity is lower than that of the debt. Therefore when calculating the WACC, the proportion of increase in cost of common equity will be less than the decline in the decline in the cost of debt thus making the overall WACC to reduce.
In the event that the company sells new shares, the cost of common equity will not change. this is because, the model of CAMP which is used to find the cost of common equity is not affected by the volume of shares but rather the risk free rate, the overall market return for the stocks in this industry and the company systematic risk factor which is determined exogenously. The selling of the shares therefore will only affect the leverage of the firm by increasing the common equity value and not the return on the common stocks (Porras, 2011).
It is a fact that at in most cases the after tax cost of debt is usually lower than that of the common equity. The main reason why most companies do not use the more debt is because the level of leverage of any firm determines its financial strength and hence its share prices. The companies who have high gearing ratio usually depict bad reputation of depending on debt and hence the potential investors would not want to invest in such companies and therefore the demand for their share would go down thus reducing their net worth. Additionally, the firm has the obligation of paying up the interest expense to the debt holders while in the scenario of common equity the value of their shares is deemed to grow hence no cash outflow that would affect the liquidity of the firm (Jorgenson, Yun, & Oxford University Press. 2011).
One of the advantages of raising capital using a debt is the fact that debt capital is usually cheaper than the equity capital. Additionally, the use of debt capital does not affect the ownership of the firm and hence the control of the firm will still remain under the control of the existing shareholders. According to Modigliani Miller, as long as the cost of debt is lower than the rate of return for the company, the company will be forever gaining wealth. One of the disadvantages of debt capital is that is increases the gearing levels of a firm and this has a negative effect on the share prices of the firm. Debt capital can lead to high cash outflow in form of interest on debt which can affect the liquidity of the firm, something that can be solved by the use of equity capital
Floatation costs usually reduce the WACC. It is usually incorporated by reducing the cost of common equity by the floating cost hence the final cost of common equity would be = cost of equity * (1-floatation cost).
Jorgenson, D. W., Yun, K.-Y., & Oxford University Press. (2011). Tax reform and the cost of capital. Oxford: Oxford University Press.
Patterson, C. S. (2015). The cost of capital: Theory and estimation. Westport, Conn: Quorum Books.
Porras, E. R. (2011). The cost of capital. Basingstoke, Hampshire [England: Palgrave Macmillan.
Pratt, S. P. (2012). Cost of Capital: Estimation and Applications. Hoboken, NJ: John Wiley & Sons.
Pratt, S. P., & Grabowski, R. J. (2014). Cost of capital: Applications and examples. Hoboken, New Jersey: Wiley.