Debt Equity Mix

Determining the Debt-Equity Mix

The Weighted Average Cost of Capital (WACC) is an essential percentage used in determining a suitable debt-equity mixture within a firm's capital structure. El Cafй, a fictitious business, was used in a simulation as a primary example for determining feasible methods of financing for proposed franchise expansions. El Cafй was faced with three major decisions in which the WACC was used as a benchmark to select the most appropriate form of financing based on the company's existing capital structure. In today's world of business, real companies are faced with similar decisions, and they must be cognizant of the significance of utilizing the WACC figure before making final investment or financing decisions. The WACC can push companies to the brink of bankruptcy or prime them for increased profitability and return on investments. This summary will incorporate a simulation example to serve as an illustration of the benefits of using the WACC to assist in the decision-making process that deals with capital structure.

Year 2001 proposed light expansion opportunities for El Cafй, a small coffee house. The debt-equity mixture was set to seventy percent debt and thirty percent equity. This decision was made based on the fact that debt costs less than equity; thus, this decision allowed the owner to minimize the WACC to 8.65% for the $400,000 venture. Year 2004 afforded further expansion possibilities. With all expansion and financing options considered, a 7-city expansion financed solely by debt proved to be the best option. This option allowed for the highest rate of return over the WACC. This is very important because the WACC acts as a discount rate for gauging subsequent cash flow amounts (Brealey et al., 2004, p. 321).

Year 2005 called for quick action to rebalance the capital structure of El Cafй, which was in financial peril. To accomplish this financial rebound, the proportion of debt was lowered to reflect El Cafй's initial capital structure of seventy percent debt, placing debt closely at 63.42%. This feat was accomplished by selling real estate and vehicles. These assets were not necessary to the operation of El Cafй. The owner also chose to forego debt renegotiation because that option was only temporary; furthermore, it would also raise interest rates and the WACC. It was for this reason that renegotiation was rejected; consequently, the WACC was lowered to 10.07%, bringing El Cafй back to its feet.

WACC is pivotal to an organization's financial success. The WACC allows the leaders of a business to gauge the possible effects of different financing alternatives. They must consider the cost of debt and equity components to maximize profitability. This can be done by using the WACC as a benchmark for determining which investments would produce the best results. Managers must look into a firm's capital structure and assess the weighted costs of common stock, preferred stock, and other debt and equity components that require a rate of return to investors. By assessing a firm's "capital structure- its mix of debt and equity financing...and consider[ing] the required rates of return of debt as well as equity to investors," managers determine what WACC figure