A brief synopsis of the concepts of managerial finance
Managerial finance is concerned with the effect of certain financial techniques on businesses. After reading the concepts presented in the textbook, the most important ones identified are the cost of capital and the weighted average cost of capital (WACC). The former one refers to the amalgamated cost of various sources such as preference shares, retained earnings, debt, and equity (Lambert, Leuz & Verrecchia, 2007). The cost of capital varies in accordance with the cost of the source. The usage of the type of source varies depending on the needs of the firm. It gives rise to the concept of WACC. Understanding both the concepts from the viewpoint of an organization and an investor is vital. One of the components of the cost of capital is the cost of debt. It signifies the rate of interest that an organization is supposed to pay while increasing the debt capital (Modigliani & Miller, 1958). An organization can reduce its tax liability because, in a real-life situation, total interest paid in order to raise the debt capital is not equivalent to the cost of debt.
In this case, the total interest is regarded as an additional expense. It is usually deducted from tax. The concept of WACC is the calculation of an organization’s cost of capital. In case of WACC, each source is weighted proportionately. Sources include preferred stock, common stock along with bonds, and long-term debt. The WACC of a firm increases with the increase in the rate of return on equity and beta. However, an increasing WACC means increased risks and decreased valuation. It is vital to understand the concept of WACC because the amount of interest owed by a company with respect to each dollar can be determined. It also helps in calculating the return that equity owners, along with lenders, can anticipate to achieve. Don't use plagiarised sources.Get your custom essay just from $11/page
Questions relevant to the presented concepts
In the case of the cost of capital, it has been understood that it can be regarded as a hurdle rate for companies as a company must overcome the capital to generate value. Its usage in accounting and economics is already popular. Companies experienced in investing in projects are more likely to take initiatives that will supposedly ensure good returns. The general norm should be investing in projects or initiatives that can exceed it. There lies a difference between the discount rate and the cost of capital. It is vital to conduct more research in this arena so that a company’s management can take less risky and highly innovative initiatives.
One of the vital questions that usually come to mind is the ways in which WACC can be used. It is anticipated that the security analysts tend to use the formula while assessing investment value and deciding the appropriate investment value. For instance, while analyzing the discounted cash flow, it would be appropriate to use WACC. In order to perform EVA or economic value-added calculations, it would be appropriate to use this concept (Fernandez, 2010). Another query arises regarding the difference between WACC and RRR or Required Rate of Return.
References
Fernandez, P. (2010). WACC: definition, misconceptions, and errors. Business Valuation Review, 29(4), 138-144.
Lambert, R., Leuz, C., & Verrecchia, R. E. (2007). Accounting information, disclosure, and the cost of capital. Journal of accounting research, 45(2), 385-420.
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American economic review, 48(3), 261-297.