This post tries to explain the concept of Weighted Average Cost of Capital (WACC) in an entirely theoretically situation.
Fictional Setup
After weeks of speculations, the federal reserve appears to have decided on how to adjust interest rates for the economy. However, before going any further, let's rewind one month and look at the potential future(s) the company Tyson Foods is forecasting.
CEO/CFO Ask
The CEO and CFO of Tyson Foods asked their staff to perform what-if scenarios on how the fed’s decision to increase or decrease the interest rates would have on their company, their weighted average cost of capital (WACC). For the CEO and CFO, upcoming Capex projects require a significant amount of capital, so they must understand how the after-tax costs of interest-bearing debt, bonds, stock, and equity influence the actual cost of capital for the firm.
Since a lot of the factors that contribute to this formula are external, executives have little ability to control it. However, they do need to be aware of how big external factors (such as changes to interest rates) would affect their ability to leverage capital.
Analysis
The staff is quite versed in such requests, as they have an excel spreadsheet created to adjust variables to see the resultant changes to their WACC. Each of their sources of capital is multiplied by a determined weight and adding the products. The analysts found that increases or decreases to interest rates did not have a straight-forward answer. For example, if interest rates increase, then the debt financing the company pursues will be most costly. Subsequently, higher interest rates decrease bond prices and push investors out of the bond market. Additionally, equity financing seems more appealing since taking a loan out is more costly.
Conclusion
As of today, Tyson Food’s WACC is 3.91, meaning that for $1 of capital borrowed, it would cost them $0.391 (Tyson Foods WACC, n.d.). Compared to its competitors, Tyson Foods as a lower WACC, which means it can more easily obtain capital to work on projects (Mackie, 2019). Additionally, with a return-on-invested-capital of 10%, Tyson Foods should borrow money because it has a high historical return rate. The feds today decided to lower interest rates. Therefore, the analysts predicted a lower trending WACC because a lot of their capital sources are not cheaper to obtain. Therefore, the CEO and CFO will aggressively seek capital funding to pursue projects with a high ROIC.
Resources
Ehrhardt, M. C. & Brigham, E.F. (2015). Corporate finance: a focused approach (6th ed.). Boston, MA: Cengage Learning.
Mackie, K. (2019, September 10). Tyson Foods Is A Terrible Investment Anywhere Over $30. Prove Me Wrong. Retrieved from https://seekingalpha.com/article/4290677-tyson-foods-terrible-investment-anywhere-30-prove-wrong
Tyson Foods WACC %. (n.d.). Retrieved from https://www.gurufocus.com/term/wacc/TSN/WACC/Tyson+Foods+Inc.
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