# The weighted average cost of capital (WACC)

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The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. WACC represents the investor’s opportunity cost of taking on the risk of putting money into a company. The expected return is the amount of profit or loss an investor can anticipate receiving on an investment. An expected return is calculated by multiplying potential outcomes by the odds of them occurring and then totaling these results. Essentially a long-term weighted average of historical results, expected returns are not guaranteed.

Chen, J. (2020, September 07). Expected Return Definition. Retrieved November 09, 2020, from https://www.investopedia.com/terms/e/expectedretur…

Hargrave, M. (2020, August 29). How to Calculate the Weighted Average Cost of Capital – WACC. Retrieved November 09, 2020, from https://www.investopedia.com/terms/w/wacc.asp

McClure, B. (2020, September 16). Investors Need a Good WACC. Retrieved November 09, 2020, from https://www.investopedia.com/articles/fundamental/…

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WACC is the weighted average cost of capital, and this is a key input for discounted cash flow analysis. This WACC is a rate at which a company’s future cash needs to be discounted to arrive at its present value. This will also reflect the perceived riskiness of the cash flows, which is the rate they use to discount those future cash flows to the present. If there is low risk, then there is a low return, and high risk gets a high return. This capital comes with the cost to the business raising the capital, and when you calculate the WACC, there has been an assumption of a stable capital structure. If the company’s current mix of debt and equity capital will persist into the future and to assume that a different capital structure (McClure, 2020; “WACC Formula & Calculation,” n.d.).

The risk and return tradeoff state that when the potential return rises with an increase in risk. When you use this principle, people associate the low level of uncertainty with the low potential returns, and this high uncertainty or the risk with high potential returns. The invested money may render higher profits only if that investor accepts a higher possibility of losses. When you calculate this appropriate risk-return tradeoff, investors will consider many factors, including the overall risk tolerance and the potential to replace the lost funds. Besides, investors consider the risk-return tradeoff of an individual’s investments and portfolios when making investment decisions. Investors also use the risk-return tradeoff is one of the essential components of each investment decision and assess their portfolios as a whole. Furthermore, the portfolio level, the risk-return tradeoff, may include assessing the concentration of the diversity of holdings and whether or not the mix presents too much risk or a lower-than-desired potential for return (Chen, 2020).

References

Chen, J. (2020, August 29). Risk-Return Tradeoff. Investopedia. https://www.investopedia.com/terms/r/riskreturntradeoff.asp.

McClure, B. (2020, September 16). Investors Need a Good WACC. Investopedia. https://www.investopedia.com/articles/fundamental/03/061103.asp.

WACC Formula & Calculation: Weighted Average Cost of Capital. Wall Street Prep. https://www.wallstreetprep.com/knowledge/wacc-weighted-average-cost-capital-formula-real-examples/.

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WACC or weighted average cost of capital is the value of a company’s operations present value of their expected free cash flows that has been discounted. The textbook further defines WACC as the weighted average of the after-tax component costs of capital-debt, preferred stock and common stock equity. With each factor weighing as a proportion of that type of capital in the optimal or target capital structure.

As in any investment relationship there is always a valuation of risk and return that needs to be taken into consideration. In most cases the higher the return on investment potential usually means the higher the risk of loss. Like in all investments there is absolutely no guarantee or formula to help ensure that you can a higher return, even when you take a bigger risk. And the same applies to a lower risk, there is still a chance that the investment will make an acceptable higher return. I believe that it is up to the individual investor as to the amount of diversity they are willing to make to determine the amount of risk you are willing to make to help your portfolio receive the deserved return you strive for.

References:

Eugene F. Brigham and Phillip R. Daves, Intermediate Financial Management, Thirteenth Edition

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One of the biggest threats to long-term success is managerial entrenchment, which occurs when corporate leaders put their own self-interests ahead of the company’s goals. This is of concern to people working in finance and corporate governance such as compliance officers and investors because managerial entrenchment can affect shareholder value, employee morale, and even lead to legal action in some instances. The most often cited examples of this are managers: pursuing acquisitions simply so they can manage a bigger organization (empire building), engaging in manager-specific investments, and constructing extravagant offices at the expense of the shareholders.

The Sarbanes-Oxley Act of 2002 is a law the U.S. Congress passed on July 30 of that year to help protect investors from fraudulent financial reporting by corporations. The Sarbanes-Oxley (SOX) Act of 2002 came in response to highly publicized corporate financial scandals earlier that decade. The act created strict new rules for accountants, auditors, and corporate officers and imposed more stringent recordkeeping requirements. The act also added new criminal penalties for violating securities laws.

Kenton, W. (2020, August 29). Sarbanes-Oxley (SOX) Act of 2002 Definition. Retrieved November 09, 2020, from https://www.investopedia.com/terms/s/sarbanesoxley…

Moffatt, M. (n.d.). What Is Managerial Entrenchment? Retrieved November 09, 2020, from https://www.thoughtco.com/definition-of-entrenchme…

Preventing Management Entrenchment. (2020, September 21). Retrieved November 09, 2020, from https://alphabridge.co/featured/preventing-managem…

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Shareholders are the company’s equity owners, and managers are the people who manage all operations related to finance, IT, HR, operations, Sales & Marketing, etc.

The following are the actions entrenched management might take that would harm shareholders: Managers focus on external activities rather than corporate tasks, which will reduce the cash balance. This, in return, will reduce the shareholder’s wealth rather than increasing their wealth. Managers might use corporate resources on activities that benefit themselves rather than shareholders. Managers might avoid making difficult but value-enhancing decisions, which harm shareholders of the company. Managers might not take too much risk, or they might not take on enough risk. If a company is generating positive free cash flow, a manager might “stockpile” it in the form of marketable securities instead of returning to investors. This gives an adverse result as it prevents them from allocating these funds to other companies with good growth opportunities. Managers might not release all the desired information by investors, which might withhold information to prevent competitors from gaining an advantage. The points mentioned above will affect the shareholders’ wealth because of entrenched management actions (Walsh, 1990).

I found this example but not sure if it applies to this or not. InBev and Anheuser-Bush, which in June 2008, the Euro-Brazilian beverage company made an unsolicited bid for iconic American beer brewer, Anheuser-Bush. Inbev offered to buy this company for \$65 a share in a deal that was valued its target at \$46 billion. The takeover quickly became to become hostile as both sides trade lawsuits and accusations. “The deal took on a soap opera-like quality as it pitted Busch family members against one another for control of the 150-year-old company. Eventually, InBev upped its offer to \$52 billion or \$70 a share, an amount that swayed shareholders to accept the deal…”(Beers, 2020). After they acquired the company, the combined company became Anheuser-Busch InBev. In 2006 the company flexed its acquisition muscle again, and they merge with its rival SABMiller in a deal worth \$104.3 billion. This was the biggest merger in history (Beers, 2020).

The Sarbanes-Oxley (SOX) Act helps the rating agencies view acquisitions with skepticism, and the view of rating agencies has become a critical hurdle in making these acquisitions. IF they do not take the neutral position, the deal will likely not be made. Sellers and buyers must now present a strong rationale for the transaction price, and mistakes or oversights can no longer be overcome by increasing stock values. Analysts are scrutinizing both the transaction financials and the underlying business strategy as never before. Scenario testing is now a mandatory part of a buyer’s appraisal, given that insurance and reinsurance contracts have many types of embedded options that may need evaluation under varying economic scenarios (Due Diligence…,” 2016).

Reference

Beers, Brian. “Top Examples of Hostile Takeovers.” 28 Aug. 2020. Web. 10 Nov. 2020. https://www.investopedia.com/ask/answers/042815/what-are-some-prominent-examples-hostile-takeovers.asp.

“Due Diligence Under Sarbanes-Oxley.” 07 Nov. 2016. Web. 10 Nov. 2020. https://imaa-institute.org/due-diligence-under-sarbanes-oxley/.

Walsh, James P., and James K. Seward. “On the Efficiency of Internal and External Corporate Control Mechanisms.” The Academy of Management Review 15.3 (1990): 421. Print.

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