Weighted Average Cost of Capital (WACC)

The calculation of a company’s capital cost using the weighted average cost of capital (WACC) method shows how each type of capital is given a proportionate amount of weight (Miles & Ezzell, 1980). All capital sources, including bonds, common stock, long-term debts, and preferred stock, are taken into account when calculating WACC. The WACC of a company rises as beta and equity return rate rise. WACC’s rise reflects rising risk and valuation, respectively.

WACC of the company reflects the return anticipated from the firm and the impact of managerial decisions. As such, the directors of the company engage in the use of WACC as a strategy to make decisions, which include the determination of the economic feasibility for the mergers and associated expansionary opportunities. Thus, WACC depicts the discount rate, which needs utilization as the cash flows in a similar manner to the overall nature of the firm.

The management styles in the organization could be conservative or aggressive. The aggressive approach focuses on ensuring that there is a quick growth of the firm, which results in the ramp up of several debts that affect earnings per share of the company (Frank & Shen, 2016). On the other hand, the conservative approach has low inclinations to the debt usage as a means of increasing profits. Hence, managers who are concerned with growth focus on borrowing money and to finance the growth. Such results in the attainment of a debt. However, the move results in the attainment of revenues that is unproven and unstable. For the mature and stable firms, debt finance is not needed since the companies generate the cash flows that are utilized in financing projects.

Market conditions also impact the capital structure. When markets are in the state of struggle money has to be borrowed without the surety of it being repaid. Further, the interest could be high as compared to the ability of the company to repay. Thus, such situations calls for ensuring that the firm is able to wait for the normalization of the market conditions prior to accessing funds to be used for the plant.

Uses of WACC

WACC is frequently used in the process of value assessment for the investment options and decisions, which should be pursued. Further, WACC is utilized in the process of conducting the economic value added (EVA) calculations and acts as the hurdle rate versus the ROIC performance. Therefore, investors use WACC to gain an indication of whether the investment option is worth pursuing. Such is because WACC gives the minimum return rate, which is acceptable for the yields obtained from the company.

Mistakes that managers should avoid

The first mistake is the desire of the managers to focus on keeping up with the pace of others in the market environment (Frank & Shen, 2016). Such denies them the chance to enjoy competition because of the limitation of the finances. Further, the manager could end up in more debts and overspending. The second mistake is to forget to take care of the unexpected. As such, the lack a contingency plan, this would address the unexpected situations.

The third is the use of software, which is outdated for the budgeting process. Such software presents challenges focused on linking different accounts. The final is the forgetting of smaller items. These are small expenditures that the firm incur, but are not included in the overall budgeting strategy.

Conclusion

In conclusion, capital budgeting concepts and WACC can be used to make decisions on whether to invest at Starbucks Company. As such, WACC will help in calculating the expected return rate from the investment decision, which is to be undertaken.

References

Frank, M, & Shen, T. (2016). “Investment and the Weighted Average Cost of Capital”. SSRN -

Journal of Financial Economics. 1 (1).

 Miles, J, & Ezzell, J. (September 1980). “The weighted average cost of capital, perfect capital

markets and project life: a clarification”. Journal of Financial and Quantitative Analysis. 15 (3): 719-730