Weighted average cost of capital is the combined rate at which a company repays borrowed capital. A business mainly raises capital from debt financing and equity capital, and computing WACC involves adding the average cost of debt to the average cost of equity. According to the "Journal the Accountancy," the reduction of WACC stretches the spread that lies between it and the return on invested capital to maximize shareholder value. A company can reduce its WACC by cutting debt financing costs, lowering equity costs and capital restructuring.
Equity cost is the return on investments that shareholders expect to earn from the company. It comprises the costs of common stock and retained earnings. The cost of equity incorporates the scope of inherent risk lurking in the profitability prospects of the company. This is known as equity risk premium, and it serves as the compensating factor for opportunity cost -- that is, alternative investments with similar risk levels the shareholders would have pursued. If you reduce a given risk, it reduces equity cost. For example, if a particular risk on future net cash flows is linked to poor market segmentation, you can reduce the risk by implementing proper market segmentation strategies.
Debt Financing Costs
The cost of debt is the interest rate applied on loans borrowed from banks and non-bank financial institutions. The applicable interest rate reflects the risks of nonpayment relative to the collateral requirements attached to the loan. Therefore, cutting the costs of debt begins with lowering the costs of nonpayment. If the interest rate of a debt is higher than the interest rate of alternative capital, your company could source the alternative capital and pay off the debt. This leaves youwith the obligation of repaying alternative capital at lower interest rates.
Your company can review the structure of its debt in a bid to reduce the WACC. One option of capital restructuring involves substituting debt for equity, because it translates to lower costs after taxation. For example, the process of raising equity attracts marginal cost of capital -- that is, the cost of raising new capital in addition to equity risk premium. The change of capital structure to accommodate more debt than equity eliminates these costs and reduces WACC. Alternatively, your company can substitute common stock with preferred stock to reduce the WACC. Preferred stock is less costly than common stock, because it attracts lower equity premium rates by virtue of its priority in dividend payout or compensation in the event of bankruptcy.
Caution must always prevail regardless of the method your company employs to reduce WACC. This is because the suitability of each of these methods depends entirely on the existing capital structure of the company. For example, if your company already has a lot of debt, it would not be wise to take on more debt when seeking to reduce equity cost. Huge amounts of long-term debts could be extremely burdensome to the company.
- Jupiterimages/Goodshoot/Getty Images