Finance Assignment

TASK 2

Team 1:

Adetolani Adeosun

Lawrence Henderson

Ayoub Mfinanga

Brittany Raines

Matthias Wurster

Memo to CFO

Executive Summary:

Team one was asked to examine ACME Iron’s current capital structure and determine the Weighted Average Cost of Capital (WACC). Comparing data from similar companies within the industry, we calculated a WACC of 5.75%.

Analysis:

During the analysis of ACME Iron’s current capital structure, we found that the company’s debt-to-equity ratio is 0.8235. The ratio computation was dividing the 2015s debt of 140,350,000 by the equity of 170,423,000. The industry’s average debt-to-equity ratio is 0.05-0.29. Therefore, ACME Iron’s debt-to-equity ratio falls in that range. The company’s debt accounts for 45% of financing and equity accounts for 55%. The weighted average cost of capital for ACME Iron is 5.75%.

Conclusion:

It is advisable to lessen debt and increase equity as our Debt-to-Equity ratio is unusually high compared to our competitors. This shows inherent risk in our company, which will deter investors, raise our fixed return rates due to high beta, and raise our overall cost of capital. Also, currently our WACC is 5.75% and should be used in any capital budgeting decisions as our discount rate. This will change if the above suggestion is acted upon.

Capital Structure and Weighted Average Cost of Capital

Calculations

After-tax cost of debt:

Rd(1-t)

8% (1-40%)= 4.8%

Cost of equity:

Cost of equity= 6.55%

Proportions of debt and equity in the firm:

Equity = 170,423,000

Debt = 130,000,000 + 10,350,000 = 140,350,000

Debt-to-Equity Ratio = 140,350,000/170,423,000 = 0.8235

Debt/(Debt + Equity) = 140,350,000/310,773,000 = 0.4516

Equity/(Debt + Equity) = 170,423,000/310,773,000 = 0.5484

How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC?

WACC is computed as:

0.4516 * 0.048 + 0.5484 * 0.0655 = 0.0576

WACC = 5.75%

Calculating the WACC requires knowing the values of the proportion of debt, proportion of equity, cost of debt, cost of equity, and tax rate. We should be concerned with the WACC because it is an essential indicator of the company’s overall cost of capital deployed in managing the business. It provides data to the company so that it can use it as a way to measure how to fund new projects. Decisions of investing in new projects use models like NPV and IRR derived from the company’s current cost of capital and the return a project will generate over its lifespan. WACC helps investors determine if an investment should be increased, decreased, or discontinued.

Any insights into the capital structure of ACME Iron?

With financing of 45% debt and 55% equity, it seems like this is a proper balancing of the two financing options. If this is a purposeful decision, this means ACME Iron is not worried about covering their debt costs. However, this will look like a large amount of risk to outside investors. The industry average Debt-to-Equity ratio is between 0.05 and 0.29 (CSIMarket, 2019). With a debt to equity ratio of 0.8235, they have significantly more debt than their competitors. This means that they use more debt to cover their projects, so if the company experiences losses or liquidation , the stockholders will get significantly less due to the preferential payment to lenders. Overall, it may be advisable to add more equity and lessen debt to attract investors and present the company as more stable

(Kenton & Hayes, 2019).

References

CSIMarket. (2019, June 4). Iron & Steel Industry Financial Strength Information.