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To calculate the weighted cost of capital (WACC) using an example, let’s consider a company ABC, which has a capital structure that is made up of 40% debt and 60% equity. The company’s cost of debt is 5%, and the cost of equity is 10%. Using the formula WACC = (E/V) * Re + (D/V) * Rd * (1-Tc), the WACC for company ABC would be: WACC = (0.60 * 10%) + (0.40 * 5% * (1-30%)) = 6%.
The potential issues with using different methods to calculate the cost of capital in different divisions are the difficulties in determining the cost of capital and the possibility of bias or incorrect calculations. Additionally, using different costs of capital for different divisions may result in inconsistencies in the allocation of capital to different divisions, potentially leading to imbalances in the company’s overall capital structure.
It is likely that more conservative divisions would receive a larger share of capital if the WACC overall was used for the hurdle rate. The reason for this is that divisions at lower risk are more likely to be able and able to reach the hurdle rate faster, which in turn makes them more eligible to receive additional funds.
Two techniques that can be used to develop a rough estimate for each division’s cost of capital include the Capital Asset Pricing Model (CAPM) and the discounted cash flow (DCF) method.
Two advantages of using ratios in financial analysis include their ability to provide a quick and easy way to compare a company’s financial performance over time, and their ability to identify potential problem areas in a company’s financial position. There are two downsides to using ratios in financial analysis: they can become misleading if not used with the right context and could be affected based on accounting choices made.
Sources:
-Garrison, R. H., & Noreen, E. W. (2020). Management accounting 17th edition. Boston, MA: Cengage Learning. -Gitman, L. J. (2017). Principles of Managerial Finance (14th Edition). Boston, MA: Pearson.
