Debt-Equity Mix Simulation

Running head: DEBT-EQUITY MIX SIMULATION

Debt-Equity Mix Simulation

The investment decision, also known as capital budgeting, is central to the success of the company. Capital budgeting is the process of evaluating and selecting long-term investments (Brealey, Myers, & Marcus, 2007, 189). Managers need to make right investment decisions for the future of the company since not all investments are equally risky. Managers need to know how to calculate the weighted average cost of capital (WACC) in order to find out risks and uncertainty related to capital budgeting. WACC is essential to an organization’s financial success. The WACC allows the leaders of a business to measure 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. Managers must calculate such financial statistics to assess whether projects would be beneficial or risky, such as major capital expenditures.

The WACC gives managers a figure by which to pinpoint a company’s cost of capital, as well as acceptable rate of return from proposed ventures. WACC considers the proportional costs of debt and equity components within a company’s capital structure to give the overall cost of capital (Brealey, Myers, & Marcus, 2007, 189). Allowing too much debt in an attempt to lower WACC may lead to bankruptcy. Banking on too much equity could mean that business partners and investors may gain too strong of a stake holding in the business, as seen by the owner’s situation of El CafÐ"©. The WACC should guide the components within the capital budget and structure to ensure that a company is making practical business decisions. Managers faced with key business decisions involving financial ventures must ensure that the rate of return on any proposed investment is in fact greater than the WACC