discussion

Do you agree or disagree with any of the concepts in post below? Provide information or concepts that may not have been considered.

Weighted Average Cost of Capital and Cost of Capital Allocation in the Real-World

Another tool for financial managers and businesses is capital allocations. Capital allocation is a way to maximize returns to shareholders by distributing the funds and financial resources for an organization. The tool allows financial managers to decide where to spend money which can help determine how quickly the organization can grow. A great example of capital allocation strategy that a company has applied is from Credit Acceptance Corp, and we find their outlined strategy in their Q3 Earnings Call (2017) is that they first make sure they have capital on hand to fund the business, and next they do buy back of their stock if the intrinsic value is less than they think it is. The company has two board members with investment experience, and they are primarily guiding the capital allocation and the board decisions. The CEO defers to them for decisions, because of his lack of experience. Their model is to make them more valuable over time but using their extra cash flow to repurchase shares when they are lower than what the company believes is its actual value.

This has proven successful in the long run, for one because the investment experienced board members are driving those decisions, and they are looking at long-term value of the company. While the company may do this in times where there is extra cash flow and the stock valuation is below where they think it should be, to do this they are potentially not diversifying enough, or even reducing debt and instead funneling cash to the same place, their stock. This disagrees with the text because the company needs to calculate the required return and the cost of capital and make sure the use of money is fruitful or right for the capital structure (Ross, Westerfield, & Jordan, 2020). The WACC is used to evaluate the investments and can represent the firm’s opportunity cost by calculating the NPV or the discount rate. For this example, that would mean that the required return on investment has the same risk as using the cash for other things, like expansion. The decision to purchase the stock is driven by the company valuing the stock higher than it is selling for, and not weighing the required return.