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Debt and Equity is WACC Essay

For companies and business owners, capital funding is consisted mainly of two components: equity and debt. Equity holders and lenders expect some returns on the capital or funds they give out. The expected return to debt holders and the shareholders or equity owners is known as the cost of capital. It is important for business owners to understand the weighted average cost of capital (WACC) as it identifies the return which lenders and equity owners can expect in the long run (McClure, 2010). In basic terms, WACC represents a special type of opportunity cost to a business owner of taking the risk of investing money in a given business.

WACC is the calculated mean of the business financing sources with each source weighted according to its respective use in a particular situation. Business owners need to know the WACC so as to determine economic opportunities for expansions or mergers for large business owners (McClure, 2010). Business owners should limit on the amount of equity and increase on the debt because business owners receive tax deductions on paid interest. The net cost of debt is expressed as the interest paid minus all tax savings which accumulate from the deductible interest payment tax, thus

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Rd (1-tax rate), where Rd is the cost of debt (McClure, 2010).

As observed, this formula is variable depending on the lender. On the other hand, the cost of equity seems higher that the cost of debt and business owners should minimize on equity to finance their business. The cost of equity affects the share price and the business has to maintain the price of its shares to satisfy the investors. What make equities to be expensive are the high expectations of the shareholders (McClure, 2010). While debt seems cheaper compared to equity for business owners, there should be a mix of sources to finance the business. The business owner will not use 100 percent debt to finance the business.

Although debt is cheaper, it is more risky and there is no obligation set to pay the interest on the amount of debt given irrespective of the loss or profit incurred. At the same time, it is not possible to raise enough capital (for larger businesses) only by means of debt: there should be a mix. Businesses opting for equities spread the risks of carrying out business. Equities will offer advantage to business value after performing well and improves the chances of being robust in the future. It is therefore advisable for business owners to finance their business both from equities and debts.

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