Table of Contents
WACC is important in coming up with the appropriate cost factor in order to balance between the loan borrowed from external sources and internal generation of resources. It helps to select the most optimal source of capital. This helps evaluate the VistaPrint’s investment risk (Focardi, 2004). The analysis is useful to potential investors in determining the most optimal portfolio to invest in.
Cost of common stock
Using the dividend model and the CAPM techniques, we get the real Cost of Capital.
The Beta factor is important in measuring the equity market volatility.
VistaPrint Beta= covariance = 1.46
As per the recently published financial statements of VistaPrint, it has a Beta of 1.46. This factor is higher by 92.11% higher than that of the Service sector. The Beta factor is also 33.03% lower than that of the Business Service Industry. The Beta factor is 224.44% lower than the firm is. The factor is useful in computing the total average cost of capital.
The Cost of debt = the risk-free rate + the company risk premium
The Cost of equity (risk-free rate + about 6% equity risk premium)
Thus, the equity risk premium is adjusted with the new company´s risk level
The level of risk for a company depends on the level of business risk (business field) and on the level of financial risk (solvency)
The company´s cost of capital is calculated as a weighted average of the above costs of the equity and debt.
The cost of capital is thus calculated with the target solvency ratio (The cost of capital cannot be decreased simply by increasing the leverage since increasing this leverage increases the risk (and cost) of both the equity and debt.)
The Debt cost includes the tax shield (1-tax rate) since interest on debt can be deducted from the taxable revenues of the company (Focardi, 2004).
Cost of debt: 5,2% + 1% = 6,2% (in the long run)
Cost of equity: 5,2% + 1,2 * 6% = 12,5%
Cost of Preferred Stock
pp r = Dp/ Vp (1-f )p
,f p=flotation costs
ex. D = 10
Vp = 100
fp = 2.5%
r p= 10 = 10.26%
100(.975) market value weights
The After-tax cost of preferred stock =before-tax cost of preferred stock
Market value weights
Instead of using book value, the market values of various sources of capital are used in assigning weights. This is more practical for raising new capital (Focardi, 2004).
Market value weights
We use the Debt: $18,000, 3.70% Preference: $9,000, 7.00% Equity $40,000, 9.50% and Retained earnings $5,000, 8.31%.
|The Source||The Book Value||The Percentage to Total %||The Cost of specific Capital %||The Weighted Cost|
|The Retained Earnings||$5,000||6.94||8.31||0.577|
The company is minimizing its WACC. The 7.66% is useful as there are reduced debts in the company (Benninga, 2006). The company is thus able to obtain resources from within and does not greatly rely on the loans. This is useful to investors as they are able to recover their investments within the shortest time possible. They are thus encouraged since the WACC is evident that the company relies less on the external sources. This is an important criterion since the use of debts increases the company’s possibility of bankruptcy in case it fails to pay the debt (Benninga, 2006).
The company is advised to maintain this level of WACC. This is because it will be able to generate and attract investors. The result of this is that there will be an increase in customers and this boost the wealth accumulation goal and the profit will thus be minimized. It should be noted that the minimized WACC would in return maximize the profits. The company will thus be in a better position compared to the competitors.