Question

Look at the WACC formula. Which type of funding costs the most return, and the least? Now how can a company reduce its WACC? Hint:Think about the MIX of the funding in the formula...

Is your answer above a good business strategy? What risks are involved?

Answer 1

Weighted average cost of capital refers to the average capital cost of the company giving weights to the type of capital used.

The WACC = The market value of the firm's equity* cost of equity + The market value of the firm's debt* cost of debt/ the total capital employed.

The funding cost of debt is most beneficial as the company saves the tax cost of interest.

The least beneficial will be the equity shares as the have all the residual profits of the firm and give no tax benefit.

A company may reduce its cost by employing more of borrowed funds.

This cannot be said as a perfect strategy as the company may involve risk of having high borrowed fund rate of interest plus the company may also find it difficult to manage as the debt increases. They may demand a share in decision making. More debt is a risk for goodwill and interest expenses of mandatory nature makes it difficult sometimes if the company does not have adequate profits.